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Full text of "Case problems in finance"

UNIVERSITY 
OF FLORIDA 
LIBRARIES 




CASE PROBLEMS IN FINANCE 



CASE PROBLEMS 
IN FINANCE 



BY 



Pearson Hunt, D.C.S. 

Associate Professor of Finance 

Graduate School of Business Administration 

Harvard University 

AND 

Charles M. Williams, M.B.A. 

Assistant Professor of Finance 

Graduate School of Business Administration 

Harvard University 




1951 

RICHARD D. IRWIN, INC. 
CHICAGO, ILLINOIS 






COPYRIGHT 1949 BY RICHARD D. IRWIN, INC 

ALL RIGHTS RESERVED. THIS BOOK OR ANY PART THEREOF MAY NOT BE 
REPRODUCED WITHOUT THE WRITTEN PERMISSION OF THE PUBLISHER 



First Printing, August 1949 
Second Printing, January, 1950 
Third Printing, January, 1951 

Fourth Printing, July, 1951 



PRINTED IN THE UNITED STATES OF AMERICA 



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Acknowledgments 



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To the businessmen who contributed the material for the cases in this 
volume we express our sincere gratitude. In the development of each case 
they gave liberally of their time, and in most instances they made avail- 
able to us facts about their businesses normally held confidential. 

Several of the older cases were first prepared under the supervision 
of Professors George E. Bates, Robert L. Masson, and Malcolm P. 
McNair. We thank them for their permission to revise the material for 
this book. 

Our thanks are also extended to the Instructors and Research Assist- 
ants of the Harvard Graduate School of Business Administration, espe- 
cially to Roger Stark, Ernest F. Kennedy, and Leonard Marks, Jr., who 
handled the field work and the drafts of many cases, and to Richmond 
F. Bingham, who designed the charts appearing in the book. 

The authors also wish to express their particular appreciation to 
Catherine M. Smith, who cheerfully and efficiently accomplished the 
mass of typing and other secretarial work associated with the prepara- 
tion of the manuscript, and to Leonard Marks, Jr., and Elizabeth L. 
V Dal ton, who not only accepted the burden of reading the proof but, in 
addition, offered excellent editorial criticism and suggestions. 

Except where credit is specifically acknowledged, the cases in this 
volume are copyrighted by the President and Fellows of Harvard Col- 
lege and are used with their permission. 

Since all the cases in this book have been revised or written by the 
authors, we accept full responsibility for the contents of this volume. 



Pearson Hunt 
Charles M. Williams 



<< 


Graduate School of Business Administration 

Harvard University 

June 1, 1949 

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Table of Contents 



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INTRODUCTION 

PAGE 

Introduction . The Uses of Case Problems 3 

PART 1. FINANCING CURRENT OPERATIONS 

The Point of View of the Financial Manager English Motor Sales, Inc. 9 

Variation in the Need for Current Funds: 

The Cycle of Current Operations — Seasonality 

Megaphytic Products Co. 18 

Growth in a Merchandising Firm . . . Clarkson Lumber Co. 28 

Growth in a Manufacturing Plant Tremblant Manufacturing Co. 33 
Explaining Changes in Financial Condition 

United American Manufacturing Co. 39 

Estimation of Requirements for Funds: 

Use of Ratios Monroe Department Store 42 

Receipt and Disbursement Schedules .... Larabee Co. 46 

Correcting Confusion in Estimation .... Linwood Co. 50 
Profit Estimates versus Cash Estimates 

Trivett Manufacturing Co. (A) 56 

Major Types of Loan Arrangements: 

Meeting a Self-Liquidating Need .Trivett Manufacturing Co. (B) 62 

Receivables as Collateral Harbin Co. 64 

Inventory as Collateral Santos Coffee Co. 72 

^ , j Garnet Abrasive Co., Inc. 81 

1 Adanac Packaging Machine Co. 91 

Changing Lenders Scott Laundry Co., Inc. 98 

Loan Program Haward Manufacturing Co., Inc. 105 



/ 

viii Contents 

PART 2. FINANCING LONG-RUN NEEDS 

PAGE 

Financial Characteristics of Securities . . Slater Quarry Corp. 115 

Planning the Capital Structure: 

Debt versus Common Stock . . . Longs treet Machine Co. 119 

Debt versus Preferred Stock .... Dixley Paper Co. (A) 130 

Loan versus Lease of Fixed Assets . . Vickery Department Swre 139 

Debt, Preferred Stock, or Common Stock Consolidated Motive Co. 144 

Dilution of Equity-Convertibility Cellulose Corp. 149 

Sale of Securities: 

Planning Security Provisions Jay Textiles, Inc. 165 

Private Placement Dixley Paper Co. (B) 180 

Privileged Subscription . . . Continental Casualty Co. (A) 182 

Value of Rights Continental Casualty Co. (B) 185 

^^ , . . f Johns-Manville Corp. 189 

Underwrmngj Pure Oil Co. 194 

Competitive Bidding — "Arm's-Length Bargaining" 

Northern Indiana Public Service Co. — Central Maine Power Co. 201 

Security Dealers and Organized Exchanges: 

Listing McKellar Automatic Machine Co. 212 

Refunding: 

Bonds Boston Edison Co. 235 

Loose-Wiles Biscuit Co. 240 



Preferred Stock . ^^^^ ^^^^^ 242 

Recapitalization: 

Preferred Stock Arrearages .... American Woolen Co. 249 
Management — Stockholder Bargaining . . Ohio Gauge Co. 257 

Reorganization: 

Fairness and Feasibility La France Industries 272 

PART 3. RESERVE AND DIVIDEND POLICIES 
Surplus and Other Reserves Mayfair-Cottle Co. 291 

Dividend Policy: 

Preferred versus Common Hilton Co. 296 

Common Nostrand Pressure Casting Co. 301 

Dividends versus Purchase of Shares . . . Curtis s -Wright Corp. 307 

PART 4. PROMOTION, EXPANSION, COMBINATION 

The Legal Form of the Business . . . . . . Leary Motors 315 



Contents ix 

PAGl: 

Financing a New Corporation , . . Supra Development Corp. 321 

Problems of Expansion Buckeye Mold & Tool Co. 332 

Merger Cambridge Metal Products, Inc. 337 

PART 5. COMPREHENSIVE PROBLEMS 

Financial Analysis Mitch el's Store, Inc. 349 

Financing Current Operations .... Jollum Grocery Corp. 361 

Planning the Capital Structure . . . Eagle Packing Co., Inc. 370 

Social Policy regarding Corporate Control 

Dayton Power and Light Co. — Morgan Stanley & Co., Inc. 381 



INDEX OF CASES 
Index of Cases 405 



INTRODUCTION 



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Introduction 
The Uses of Case Problems 

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Since it is likely that many readers have not worked with case prob- 
lems before, we will describe in this introduction what case problems 
are and what advantages we feel can be gained from their use. 

Each of the cases in this book represents a statement of an actual 
business situation. In almost every case a businessman is confronted 
with a financial problem which calls for decision on his part. Sufficient 
background information is given in each case to enable the student 
to adopt the point of view of the person facing the problem and to work 
out a sensible analysis looking toward action on the problem presented. 
It is expected that students will have available a standard finance text or 
reference book and that they will draw freely upon such a book for gen- 
eral background information not provided in this casebook. 

Reference to the Table of Contents will indicate that the cases se- 
lected represent problems in most of the major areas covered in finance 
courses. It will be apparent that the authors have given especial emphasis 
to certain areas which, in the authors' view, are inadequately treated in 
the leading texts. This is particularly true of the area of "financing cur- 
rent operations." 

Although most of the cases are taken from the recent experiences of 
business, some cases from years of cyclical decline and depression have 
been included. Also, in selecting the cases for inclusion in this volume 
an effort was made to tap the experiences of businesses in widely differ- 
ent fields. Finally, the reader will find that a large number of cases in- 
volve small- and medium-sized businesses and that only a few refer to 
the largest corporations. 

This case material is prepared as a basis for class discussion. It is not 

3 



4 Case Problems in Finance 

designed to present either a correct or an incorrect illustration of the 
handling of administrative problems. 

The authors realize that the time available for work with these cases 
will vary widely. Since some instructors may desire to take up only a 
portion of the cases in this book, almost all the cases are so written that 
they can be taken up independently. 

In regard to advantages that we feel can be derived from the use of 
case problems, perhaps their greatest value is that they require the stu- 
dent to work through to a recommendation for action. He cannot stop 
with an understanding of the facts of the case or with a listing of the 
matters to be considered. To be effective, he must actually think through 
to a decision suitable to the facts, and in class discussion he must be able 
to present and defend his ideas and judgment against the ideas of others. 
The need to reach a conclusion from the facts at hand and to discuss it 
intelligently is a great force in learning, helping to provide that elusive 
quality of "depth" that is often missed when learning is restricted to the 
reviewing of facts and views that others have codified. 

Since the cases in this book represent business situations selected so 
as to present debatable alternatives of action, they present problems 
which can be narrowed by the usual techniques but not settled by any 
mechanistic approach. Judgment must enter into the process of decision 
making, and therefore unanimous agreement as to the best decision is 
neither an expected nor a desired result of class meetings. Students ac- 
customed to work with technical or scientific problems, where precise 
and definite conclusions can be reached with confidence, may find at first 
that the absence of a single "right" answer to many of the issues pre- 
sented in these cases is disturbing and even frustrating. 

In developing a logical approach toward the problems presented, the 
student should not overlook the human factors. In many, if not all, of 
the cases the choice between financial alternatives depends in part upon 
the particular viewpoints of the personalities involved, particularly with 
reference to their willingness to take risks. An apocryphal anecdote may 
be cited in support of the need for full recognition of personal factors in 
financial questions. It is said that the late Baron Rothschild, during his 
prime as a leader of finance in London, was visited by a young man who 
had recently become the heir of a large estate formerly in the control of 
a personal friend of the Baron's. "Sir," the young man said, "my father 
told me to seek your advice about how to invest the funds which have 



Introduction 5 

come to me." The Baron looked at him for a moment and then said, 
*'Young man, do you wish to eat well or sleep well?" 

While work with cases may in some instances require more of the 
student's time than mere reading requires, the satisfaction of dealing 
with problems which help to bridge the gap between classroom study 
and business action and the zest of thinking for one's self are usually 
adequate recompense for any extra time employed. 



PART 1 

FINANCING CURRENT 
OPERATIONS 



I 



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English Motor Sales, Inc. 



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Early in September, 1948, Mr. Gordon Campbell moved from the 
position of new car sales manager of English Motor Sales, Inc., to be- 
come treasurer of the corporation. Although Mr. Campbell had held the 
post of bookkeeper for the company early in his 20 years of continuous 
work with the firm, he had never before had occasion to consider how 
the problems of a treasurer might change his point of view toward the 
activities and policies of the company. 

English Motor Sales, Inc., held an exclusive dealership franchise in 
a southeastern city for the Chevrolet Motor Company, a division of 
General Motors. New car sales varied between 250 and 500 units 
per annum. The business had been organized in 1928 by Mr. James 
English and Mr. Mark Herring. Although both men held an equal 
amount of the stock, only Mr. English participated actively. He had 
served as president of the company from its organization. 

English Motor Sales, Inc., rented the building where it carried on its 
operations from a second corporation owned jointly by Mr. English and 
Mr. Herring. 

In September, 1948, the activities of the auto sales firm were divided 
into departments as follows: ( 1 ) new cars, now under James Mitchell; 
(2) used cars, under Joe Waters; (3) service, under Robert Ellis; and 
(4) parts and accessories, under John Grant. All of the departmental 
managers had been employees of the firm for more than 1 5 years. 

As he took up the work of treasurer, Gordon Campbell knew that it 
was the settled policy of the owners to develop and maintain a long-term 
business rather than to attempt to gain maximum short-run profits at the 
expense of customers and employees. Looking back over his experience 
in the early years, Mr. Campbell recalled that there had been almost con- 
tinuous struggles to maintain solvency in the years 1928-1934. These 
had been reflected in strict economies, restriction of opportunity to de- 



10 Case Problems in Finance 

velop business, and the like. With this background, Mr. Campbell knew 
that the owners would want the financial management to avoid such a 
condition at any time in the future. But, while he recognized this goal 
clearly, Mr. Campbell was not sure how it might affect his policies as 
treasurer. 

A forecast of the balance sheet position of the company at December 
31, 1948, had been prepared by Mr. Campbell's predecessor and is 
shown as a pro forma statement in Exhibit 1 (p. 16) . Mr. Campbell was 
much impressed by the large sum projected for the cash account, 
$34,650, especially in view of the large amount of U.S. Treasury bonds, 
$77,300, that also appeared. These bonds could be sold on the securities 
market with a slight profit over their book value, and the proceeds of 
sale could be received in cash within 24 hours. Thus, Mr. Campbell saw 
that the firm was expected to have $111,950 in cash, or the equivalent, 
at the end of the year. This would be over one-third of the total assets, 
and an increase of about $28,000 since the beginning of the year. 

As sales manager, Mr. Campbell had been comfortably aware that 
the company was currently in a very liquid position, but in his new re- 
sponsibility he wondered whether this high degree of liquidity was nec- 
essary or desirable. 

The accounting records of English Motor Sales, Inc., were kept ac- 
cording to a standard system furnished to Chevrolet dealers by the Gen- 
eral Motors Corporation. In this system, income and expense were al- 
located under the following department titles: {a) new car, {b) used 
car, {c) service, {d) parts and accessories, and {e) administrative. Ob- 
serving that the projected income statement details were available for the 
year 1948, Mr. Campbell decided to have them at hand for possible 
guidance. The departmental budgets appearing in Exhibit 2 (p. 17) 
were confusing to Mr. Campbell, but he thought that some of the totals 
might be useful. 

Mr. Campbell first thought of the activities of his former depart- 
ment, new car sales, with the idea of reviewing the operations from his 
new viewpoint. Market research indicated that, after providing for hous- 
ing and insurance, the typical family considered an automobile the next 
purchase to be made. As automobiles had almost doubled in price since 
the 1930's, Mr. Campbell and Mr. Mitchell, the new sales manager, felt 
that the ability of sales personnel should be high in order to do a good 
job of selling in a market that was expected to become increasingly difii- 
cult. The problem of "overselling" also required high-grade personnel, 



English Motor Sales, Inc. 11 

as the experience of English Motor Sales, Inc., in 1929 and 1930 made 
clear. Of the 399 new cars sold in 1929, 228 had been repossessed by 
the end of 1930. 

Prior to the war, new car sales compensation had been solely on a 
2.5% to 3% commission basis. The normal year being seasonal, this 
scheme of pay had made sales personnel insecure and consequently un- 
reliable. In the postwar years, it had not been necessary to have salesmen. 
The sales manager and other salaried personnel handled the sales work. 

As the company's experience indicated that three or four good men 
would account for most of the new car sales in a competitive year, Mr. 
English and Mr. Campbell had worked out a plan for salaried salesmen, 
one to be hired for each 100 new cars to be sold in a year. The men were 
to be paid $250 and expenses per month, with commissions over a sales 
quota. A good man could expect to gross at least $8,000 in a good year. 
The institution of this policy, however, awaited the development of a 
more nearly "buyers' " market. 

In 1948, James English was running an inventory of about a dozen 
new cars, but Mr. Mitchell thought there should be a stock of at least 
50 new cars as soon as the supply-demand situation permitted. In or- 
dinary years, sales were lost if a customer had to wait long for his car. 

It was the established custom of the trade for the retailer to pay the 
manufacturer "at sight" upon receipt of shipments of cars. While estab- 
lished dealers, such as English Motor Sales, Inc., could borrow from local 
banks to pay for the new cars as they were received into the inventory, 
the interest rate formerly paid by the firm was 8%, which Mr. Camp- 
bell thought was quite high. 

Often the purchasers of new cars found it necessary to borrow part 
of the purchase price. Many banks and finance companies were glad to 
buy the retail notes so created, so that the dealer did not have to carry 
the customer. Mr. English, however, had adopted the policy of carrying 
the time payment notes of his best risks, as the gross rate of return on 
such notes ran from 12% to 9%. A full-time collector had been em- 
ployed to supervise these loans, with the plan to keep such receivables to 
a level of $50,000 or more. 

As sales manager, Mr. Campbell had been concerned about the 
adequacy of display and other storage space, for the parts department 
had expanded to occupy most of the building formerly allocated to the 
sales department. Mr. English had indicated that he might approve a 
plan of expansion, if co-ordinated with the needs of the other depart- 



12 Case Problems in Finance 

ments. There had been no discussion of whether the expansion would 
be owned or rented. Mr. English had indicated great reluctance to build 
while building costs were at the current high levels. He understood that 
no contractor in the city was willing to do any work on a fixed price 
basis because costs were rising so rapidly. 

After reviewing the program of the new car sales department, Mr. 
Campbell considered the nature of the operations of the other depart- 
ments of the business. Under prewar conditions, a used car department 
was regarded as a necessary evil by the retail automobile dealer. Often 
the "trade-in" represented the dealer's profit in the new car sale and 
there was pressure to dispose of used units rapidly. In general, a used car 
department was regarded as being successful if it "broke even" in its 
operations. Thus Mr. Waters, who became used car manager in 1936, 
was praised for producing a gross profit, totaling $2,202 for the six 
years, 1936-1941. 

In the English company, the new car manager appraised the car to 
be traded. The car was then transferred to the used car department with 
the allowance value as the cost of the car. The used car manager de- 
cided what repairs to make, and these were added to the cost. The used 
car manager also set the selling price. The subsequent sale might pro- 
duce another traded car or might be for cash. Used cars could be fi- 
nanced in a manner similar to time sales financing of new car sales. 

From the resumption of new car sales in November, 1945, until 
September, 1948, 92 used cars had been sold with a gross profit of 
$10,714. This amounted to an average of $117 gross profit per unit; 
yet the used car department operated at an average net loss of $65 per 
month. This was the result of a policy of fair treatment of customers, on 
which Mr. English insisted, to maintain the long-run standing of the 
company. Trade-ins were not insisted upon when new cars were sold. 

Prior to the war the department had been operated with two me- 
chanics and six salesmen in addition to Mr. Waters. Mr. Waters planned, 
however, to add two or three salesmen shortly and to adopt the scheme 
proposed for the new car department. The salary would be $220 per 
month, with the quotas set to produce an equal amount per month by 
commissions averaging $20 per car. 

New car sales being seasonal, the inventory of used cars varied ac- 
cordingly. Prewar experience showed that the inventory ran 1^ times 
the number of new cars sold in the preceding month. The average cost, 
prewar, had been $250 per car. In 1948, the average was $600. 



English Motor Sales, Inc. 13 

As a successful manager, Charles Waters knew that his primary job 
was to turn used cars into cash as rapidly as possible. General Motors 
stated that a 20-day cycle was the optimum period. Mr. Waters had al- 
ways been persistent in his resistance to the tendency of merchants to 
retain an article indefinitely rather than to take a loss. In fact, he was 
considering an "automatic" markdown plan, as had been adopted in 
some department stores. 

On the other hand, Mr. Campbell recalled that in the 1930's, when 
the English company had been hard pressed for money, losses of the 
used car department had been increased by too much pressure to sell. 
Also, the development of independent used car lots had caused Mr. 
Waters to consider holding cars until a group had been accumulated, 
with the idea of selling them on a wholesale basis to one of the operators 
of the independent lots. 

The used car department did business on a lot owned by the sales 
company, which was adjacent to the building that housed the other de- 
partments. Presumably, expansion of the building would use this lot. 

The service department of English Motor Sales, Inc., had enjoyed 
recently a very high level of activity. In fact, the large profits of the 
firm in recent years could be attributed more to the service and parts 
departments than to car sales. A common test of success for retail auto- 
mobile dealers is whether the gross profits of the service and parts de- 
partments are sufficient to absorb all the overhead costs of the firm. 
Then, with the used car department breaking even, the profit of the new 
car sales department after selling expense can be taken as profit of the 
firm. Referring to Exhibit 2, Mr. Campbell saw that this was approxi- 
mately the condition of his company. 

Experience during the war years caused owners to learn the service- 
ability of cars that were properly maintained. Even with new car pro- 
duction under way, the volume of demand for service had held at high 
levels until the summer of 1948, when there had been some slacking 
off. The best opinion available, however, indicated that the decline 
would not be a major one. Statistics indicated an average service of 
90,000 miles by cars scrapped in 1948. This was an increase of 50% 
over prewar years. 

The Chevrolet Motor Division of General Motors had considerable 
influence over the policies of the service departments of its dealers. It 
was a requirement of continuance of the dealership that service be 
available on an uncurtailed basis whatever might be the general eco- 



14 Case Problems in Finance 

nomic conditions. Also, the manufacturer had estabhshed standard labor 
costs for the more common service jobs. These had been established by 
studies of average workers working under average conditions. The times 
so established were used with a standard rate, which in the southern re- 
gion was $2.00 per hour, to establish the labor cost of the job. The 
mechanic received 50% of this sum for his work, while the company 
took the balance. Although this system of incentive pay had been pro- 
tested by the mechanics when it was installed in 1942, it had become 
popular, as efficient mechanics were often able to take home more per 
week than the supervisors. 

The service department at English Motor Sales, Inc., had been di- 
vided into two sections for the service of passenger cars and trucks. 
Passenger cars were repaired in the back end and on the roof of the main 
building, while trucks were serviced in a reconstructed warehouse in 
the rear. Under the enthusiastic supervision of Fred Hill, the truck re- 
pair volume frequently equaled the service sales on passenger cars. The 
facility met a growing demand from the owners of light and medium 
trucks, such as farmers and merchants. Mr. Hill had talked recently with 
Mr. English about a contract service plan he had devised, which he 
thought could be made so attractive that many fleet owners would close 
their own shops. The per hour labor charge would need to be lowered, 
but the increased volume of parts sales and the contribution to overhead 
would justify the program. 

Mr. Ellis, of the passenger car service division, was working on plans 
to reduce the costs of his department. With the exception of major jobs, 
it was almost impossible to schedule customer work. This created fluc- 
tuations in the shop which were exasperating to the foreman, and gave 
large variations in the take-home pay of the mechanics. Mr. Ellis be- 
lieved that the establishment of a pickup and delivery service for cus- 
tomers might be desirable. He had said that the investment of $1,000 
in motorcycle equipment would be justified. 

Both Mr. Ellis and Mr. Hill had steadily urged on Mr. English the 
need for a body and paint shop. Body work was being turned away or 
subcontracted, although the demand for such work was growing steadily. 
The paint shop was a bottleneck at current volumes, and unhealthful 
conditions existed. The paint shop could be made adequate without using 
greater floor area, but major alterations would be needed. There was no 
room for a body shop in existing buildings. In fact, light service work 
was done out of doors whenever the weather permitted. 



English Motor Sales, Inc. 15 

The personnel in the service department had a high experience 
level of service with the company. The 14 mechanics and helpers had 
an average of 11 years' service with the firm. Mr. Ellis had been in 
charge for 15 years. Mr. Hill, a newcomer, joined the firm in 1946. 

Mr. Campbell knew that Mr. English had done some thinking about 
how to protect the service employees if demand should shrink rapidly. 
Other firms used loss-leader promotions, package overhauls, etc., which 
Mr. English thought might introduce some elasticity into the demand, 
ii occasion warranted. 

From past executive conferences, Mr. Campbell had learned that 
the prospects for sales of parts and accessories indicated continued high 
levels. Older cars were not being retired as fast as new cars were being 
produced, and the prewar cars had reached ages at which minor re- 
placements were frequent. 

The English company had increased its sales of parts and accessories 
faster than most dealers. Mr. English had established the policy of carry- 
ing complete stocks, with the inventory averaging over $100,000 in 
recent years. Thus Mr. Grant, the department manager, was able to 
service other dealers and garages v/ho were without parts. Mr. English 
felt that the prestige built by this service was a source of sales in other 
departments as well as in the parts department. 

Early in 1948, the "Partsmobile," a truck with stock in bins, had 
been put on the road to sell genuine Chevrolet parts to independent re- 
pairmen within a 7 5 -mile radius. By September, Mr. Walter James, the 
salesman-driver, had added about 150 accounts and $80,000 to the sales 
volume. When the mobile selling unit was inaugurated in February, 
Mr. James had had eight competitors. By September, all but one had 
gone out of business. Mr. Grant was considering adding another Parts- 
mobile as well as a light truck for "hurry-up" orders. 

In 1948, Mr. Grant's department employed five people in addition 
to Mr. Grant and Mr. James. The inventory was stored in the most 
modern bins, but its bulk had outgrown the space near the shop where 
operations had begun in 1928. Two-thirds of the display floor, a tem- 
porary shed on half of the roof, another shed on the used car lot, and 
miscellaneous spaces were crowded with stock. This condition not only 
slowed service but led to easy pilferage and some deterioration. 

The cost of stock had risen several times since prewar years. Mr. 
Grant had been able to anticipate several major price rises, so that there 
was considerable unrealized profit in the inventory. 



16 Case Problems in Finance 

In connection with the general overhead expenses in the English 
company, which were chiefly for rent and salaries, Mr. Campbell knew 
that the rent was unlikely to change more than any increase in costs 
because the building was owned by Messrs. English and Herring. When 
he had talked with Mr. Campbell about taking the job of treasurer, 
Mr. English had said that he expected to talk soon with the salaried 
personnel. He thought that the cost of living problem could best be 
met by a bonus scheme, based on a schedule of percentages of depart- 
mental gross margins. 

The first dividend by the company, $9,000, had been paid in 1948. 

As he considered the above facts about English Motor Sales, Inc., 
Mr. Campbell had noted a number of trends, or possible policies, which 
had a bearing upon the supply and use of cash funds. In order further 
to specify to himself what his new job included, Mr. Campbell began 

Exhibit 1 

ENGLISH MOTOR SALES, INC 

Pro Forma Balance Sheet, Estimated for December 31, 1948 

ASSETS 

Current assets: Dollars Per Cent 

Cash 34,650 10.9 

Receivables, time paper 55,000 17-3 

Inventories: 

11 new cars 13,750 4.3 

3 used and repossessed cars 1,800 0.6 

Parts and accessories 100,000 31.5 

Supplies 1,200 0.4 

U.S. Treasury bonds 77,300 24.3 

Prepaid expenses 1,400 0.4 

Total current assets 285,100 89-7 

Fixed assets: 

Furniture, machinery, etc., after deduction of estimated depreciation . . . 30,300 9.5 

Deferred expenses 800 0.3 

Other assets 1,700 0.5 

Total assets 317,900 100.0 

LIABILITIES AND CAPITAL 

Current liabilities: 

Accounts payable , 30,000 9.4 

Accrued local and federal taxes 40,000 12.6 

Total current liabilities 70,000 22.0 

Capital: 

Capital stock, 300 shares 30,000 9.4 

Surplus 217,900 68.5 

Total capital 247,900 78.0 

Total liabilities and capital 317,900 100.0 



75,600 


264,000 




$ 56,400 


$ 84,000 


. . . $292,800 


None 


None 




3,600 






$ 3,600 




... $ 19,080 



English Motor Sales, Inc. 17 

to list the additional information which he would like to collect in order 
that he could keep in touch with developments from a treasurer's point 
of view. He still felt that the large amount of cash funds that would be 
on hand in December was probably excessive, but he wanted to be sure 
that he had overlooked no important possibility affecting the amount 
actually needed by the business. 

Exhibit 2 

ENGLISH MOTOR SALES, INC 

Pro Forma Statement of Estimated Income and Expense, Year 1948 

Parts, Adminis- 
New Car Used Car Service Etc. trative Total 

Number of cars sold 432 36 

Net sales $636,000 $26,400 

Cost of sales 488,400 21,600 

Gross profit $147,600 $ 4,800 

Expenses: 

Variable selling expense: 

Salesmen None None 

Delivery, advertising, etc. . . . 14,520 960 

Total $ 14,520 $ 960 

Semifixed overhead: 

Supervisory salaries 4,500 4,500 9,600 $ 4,800 $13,200 

Salaries and wages 3,600 7,200 19,200 15,000 

Office supplies, etc 6,420 

Other supplies 7,200 300 

Demonstration and company 

car 300 120 1,200 1,800 2,400 

Freight, etc 1,800 

Travel, entertainment 4,500 

Advertising 1,200 1,800 1,800 1,200 

Other 2,400 

Total $ 9,600 $ 4,620 $ 27,000 $ 29,700 $45,120 $116,040 

Fixed overhead: 

Rent 3,900 4,500 5,400 4,500 

Maintenance 7,680 

Insurance 3,600 

Power 2,400 

Taxes 4,800 

Depreciation 2,400 3,000 

$ 3,900 $ 4,500 $ 7,800 $ 7,500 $18,480 $ 42,180 

Total expenses $ 28,020 $10,080 $ 38,400 $ 37,200 $63,600] 

Administrative expenses allocated . $ 13,200 $ 3,600 $ 26,400 $ 20,400 [ $177,300 

Total expenses restated 41,220 13,680 64,800 57,600 J 

Operating profit or (loss) 106,380 (8,880 ) (8,400) 26,400 $115,500 

Bonuses $ 25,500 

Income taxes 33,360 

Dividends 9,000 

$ 67,860 



^VVVVVVVWWVVVVVVVVVVVVVVV^AAVVVV\VVWVVV\VVVWVVl\VV^VWVM^^ 



Megaphytic Products Company 



l\VVVV\VVVVVVVl\VVVVVlAaVVVVVV\VVVVVV\VVVVWaV\AVVVVA\VVV^^ 



In November, 1948, Mr. R. L. Hughson, president and treasurer 
of the Megaphytic Products Company, was reviewing the operations 
of the company over the past two years in preparation for a forthcoming 
visit at the company's bank. In the late fall after he received the auditor's 
report, it was Mr. Hughson's custom to pay an annual visit to the bank, 
located in a city some distance from the plant, to discuss with loaning 
officers the company's plans for the coming year and to make general ar- 
rangements to borrow the funds needed to finance the anticipated opera- 
tions during the year. In preparing for the 1948 trip, Mr. Hughson 
hoped to determine from a consideration of the operations of the past 
two years whether a similar pattern of borrowing was probable for 
the forthcoming season. 

The Megaphytic Products Company was a well-known manufacturer 
and distributor of fertilizers and insecticides in a four-state area. Al- 
though it had been incorporated in 1858, its common stock was closely 
held by members of a few families. Its plant and main offices were lo- 
cated in the small community where it had been founded. 

Although production was carried on at a fairly constant rate through 
the year, sales of the products were concentrated in the spring months. 

In recent years, sales of fertilizer had accounted for about 70% of 
the company's volume. Like most manufacturers of fertilizer the com- 
pany purchased the basic ingredients in bulk from major chemical con- 
cerns. It mixed these ingredients, chiefly superphosphate, potash, and 
sulphate of ammonia, according to various formulas and bagged the 
mixture in 100-pound bags. Since the manufacturing operation was a 
simple one, not more than 1 5 men were employed for direct labor and 
the plant payroll amounted to about $35,000 per year. Raw material 
composed well over half the cost of the fertilizer; plant overhead, sell- 
ing and administrative expense about one-quarter of the cost. 

18 



Megaphytic Products Company 19 

Certain conditions of availability of the basic raw materials made 
year-round production of fertilizer necessary. Relatively short supplies 
of some of these materials in recent years had enabled suppliers to insist 
on purchase contracts which called for monthly deliveries. Some price 
concessions, however, were made under such contracts. Thus, potash, 
which constituted about 12% of the company's fertilizer, had to be 
contracted for by July 1 of each year for delivery over the following nine 
months in order to secure a 1 2 % discount. If an order was placed after 
July 1, but before October 1, a 5% discount was granted. Supplies of 
this chemical for April, May, and June were purchased as needed during 
these months on a "net" basis. 

Superphosphate, which made up 30% of the fertilizer, presented 
another problem. The company's supply came largely from Florida and 
was shipped to it by barge up the Atlantic coast and up the Hudson 
River. Upper river conditions were suitable for river shipping only dur- 
ing the months from July to December. Since land shipment of this 
bulky raw material was prohibitively expensive, the entire year's needs 
of superphosphate were accumulated between July and December. 

In the case of all the basic raw materials for fertilizer, trade custom 
dictated cash payment on delivery. Purchase terms and other details of 
the major raw material ingredients are given in Table 1. 

In 1945 the company added a line of insecticides and miscellaneous 
garden tools to its product lines. In the case of these lines the company 
acted essentially as distributor, buying most of the goods in finished 
form. Up to December, 1948, as an aid in financing the purchase and 
sale of the insecticides, the company's suppliers gave winter and spring 
shipments a dating of May 1 with terms of "1 % 10 days, net 30" from 
the May 1 date. However, after December, 1948, terms were to be "net 
30." Purchases would then be made about 45 days ahead of need. 

The company averaged about a 10% markup on insecticides, al- 
though on some items the markup was much lower. Typically, the over- 
all gross margin became smaller as the selling season advanced, since 
insecticides composed a larger share of the sales. 

The company sold through retail outlets, such as grain and hardware 
stores, and directly to larger farmers in four states. Several salesmen 
on a salary and commission basis solicited orders from some 2,550 ac- 
counts, divided about equally between the farmers and retailers. Farmers 
took on the average about 15 tons, or $800 worth of fertilizer a year, 
yet the largest account, that of a farmer, amounted to $8,000. 



20 



Case Problems in Finance 



The salesmen commenced to list fertilizer orders in November, but 
few shipments were made until January and February. March, with 
25% of sales, and April and May, each with 30% of sales, were the 
months of peak shipment; by May 31 the fertilizer selling season was 
virtually over, leaving only 1 5 % of sales scattered evenly over the rest 
of the fiscal year. 

One of the objectives in adding the lines in 1945 was to reduce the 
seasonality in the company's sales. The insecticides and tools were sold 
in large volume during May and June, each 30% of sales, with 20% 
of sales throughout the summer, ending about October 1 . The first three 
months of the year accounted for the balance of sales. 

Table I 
PURCHASES OF RAW MATERIAL FOR FERTILIZER 



Raw Material 


Per Cent 

of Total 

by Weight 


Time of Order 


Time of Delivery 


Terms 


Superphosphate 


32 
19 
12 

7 

5 
3 

2 

1 

1 

18 


June for year 
June for year 
June and April 
y2 June, 3^ 

Nov. or 

Dec. 
June for year 
June for year 

Between July 

and Oct. 
Between July 

and Oct. 
Between July 

and Oct. 
Between July 

and Oct. 


July to Dec. 1 
Equal monthly 
Equal monthly 
Monthly scattered 

Equal monthly 
Depends on arrival 
from South 
America; (usu- 
ally Dec. and 
May) 
As needed 

As needed 

As needed 

As needed 


Net cash on arrival 


Sulphate of ammonia ... 

Muriate of potash 

Castor pomace 


Net cash on arrival 
Net cash on arrival 
Sight draft on ar- 
rival 

Net cash on arrival 
Net cash on arrival 

Net cash on arrival 


Nitrogen solution 

Nitrate of soda 

Bone 


Ammonium nitrate 

Uramon 


Net cash on arrival 
Net cash on arrival 


Miscellaneous 


Net cash on arrival 








100 





As an incentive to prompt payment by customers, the company of- 
fered substantial prompt payment discounts on fertilizer. Although 
sales were billed "net October 1," by which time the farmers would 
generally have marketed their crops, discounts of 1 2 % were offered for 
payment within 10 days of delivery to the customer. Smaller discounts 
were offered for less prompt payment after delivery. For example, pay- 



Megaphytic Products Company 



21 



ment before July entitled the customer to a discount of 3 % and before 
August to 2 % . Interest at the rate of 6 % per annum was charged on 
all accounts owing after October 1. 

During depression years only about 60% of the customers took ad- 
vantage of the full 12% discount. Mr. Hughson recalled that at one 
time his predecessor had said that in the 1920's "the company made 
more money in the banking business than in the fertilizer business." In 
recent years, however, about 80% of the customers took the maximum 
discount. In addition to the prompt payment discounts, the company 
offered moderate discounts on large orders. 

Over the years the company had attempted to encourage its cus- 
tomers to accept early delivery. For example, the company offered to 
pay the costs of insuring the fertilizer while it was stored in the farmers' 
barns. Efforts in this direction had done little, however, to change the 
seasonal pattern of its sales. 

Table 2 





TIME 


AND TERMS OF SALE 




Product 


Per Cent 
of Dollar 

Sales 


Time 
of Order 


Time of 
Delivery 


Terms 


Fertilizer 


70 
30 


Nov.-Feb. 
April-July 


Jan. -May 
May-Sept. 


12% 10 days, net Oct. 1 
1% 10 days, net 30 


Insecticides and miscel- 
laneous 



Terms on insecticides up to December, 1948, were "1%' 10 days, 
net 30," the same as received from the suppliers. However, when the 
terms became "net 30" after December 31, 1948, Mr. Hughson planned 
to change his selling terms accordingly. A summary of the terms of 
sale, time of order, and delivery for the company's products is given 
in Table 2. 

Strenuous efforts were made to keep bad debt losses at a minimum. 
In forming an opinion on whether to accept particular credit risks, Mr. 
Hughson relied primarily on the information in reports from credit 
agencies, although he had found the information in some of the reports 
quite incorrect. 

The company had done business with the Stuyvesant National Bank 
in a large city for many years, both as a depositor and a borrower. The 
relationship had been a cordial one, and the company had been able to 
secure the funds it needed to borrow. 



22 Case Problems in Finance 

On the basis of an annual discussion of the position and plans of the 
company, an informal understanding was reached as to the probable 
needs of the company during the next year. The yearly audited state- 
ments, showing the September 30 balance sheet and the annual income 
statement, as shown in Exhibits 1 and 4, were taken to the bank by Mr. 
Hughson at the time of this discussion. Although interim statements, 
such as those in Exhibits 1,2, and 3 were prepared for the management, 
the bank had never asked to see them. 

In the absence of unusual developments during the year, Mr. Hugh- 
son had little direct contact with the bank. Mr. Hughson attempted to 
maintain a deposit balance of at least $8,000. When the balance de- 
clined near this figure, Mr. Hughson talked with his superintendent and 
reviewed the amount of material scheduled to arrive at the plant during 
the next three weeks. From the information secured, he determined the 
amount, if any, to be borrowed from the bank to keep the balance at the 
desired level. If money were needed, he drew up a note (or notes), 
usually in $5,000 or $10,000 amounts, for three months, signed it for 
the company, and forwarded it to the bank. As long as total borrow- 
ings were within the limits established in the annual discussions, the 
bank accepted the note in routine and credited the company's account 
for the face amount less interest for three months. 

For some years, the bank had charged the very low rate of 1|% per 
annum, but in 1947 the rate was raised to 2%. In 1948 the bank ad- 
vised that its new rate would be 2^%. Mr. Hughson protested this ac- 
tion, and as a result the bank agreed to "split the difference" and charged 
2k%. 

The company had $53,000 United States 2\% bonds, which it had 
carried for a number of years. At one time, Mr. Hughson raised the ques- 
tion with Mr. Burns Williams, a loan officer of the Stuyvesant National, 
whether these should be sold and borrowings correspondingly reduced. 
Mr. Williams advised against disposing of the bonds, pointing out that 
the company received more interest on them than it paid the bank for 
money borrowed. 

It had usually proved necessary to begin borrowing from the bank 
in October and November, and borrowings generally reached a peak 
in February. In 1946 borrowing began in November. Repayment be- 
gan in March and was completed in May. In 1947 borrowing com- 
menced in October, reached a peak in March, and again ended in 
May. 



Megaphytic Products Company 



23 



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24 



Case Problems in Finance 



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26 Case Problems in Finance 

In November, 1948, after Mr. Hughson received the auditor's re- 
port he began to consider the company's needs for the 1949 season. He 
expected sales to be about the same as in 1948 or perhaps a little less. 
This was because the government farm price support program required 
that the potato acreage be cut 20%. As the potato growers took about 
20% of the fertilizer tonnage, Mr. Hughson felt that the company 
might experience a drop in sales to these producers. 

Most of the salesmen reported that the farmers were holding back 
on their orders. Evidently they planned to wait until the last moment 
before they committed themselves. Mr. Hughson felt that, unless eco- 
nomic conditions deteriorated greatly, the farmers would still buy in 
the long run about as much fertilizer and insecticides as they had been 
accustomed to buying. However, the fact of the farmers' holding back 
until the very last would cause Megaphytic to store the inventory for a 
longer period. 

Exhibit 3 

MEGAPHYTIC PRODUCTS COMPANY 

Inventory Detail 

Quarterly, December 31, 1947 to September 30, 1948 

(Dollar figures in thousands) 

Dec. 51 Mar. 31 June 30 Sept. 30 

1947 1948 1948 1948 

Fertilizer: 

Raw material $218.5 $251.3 $106.7 $204.7 

In process 270.9 155.8 13.7 97.3 

Finished goods 13.9 73.0 10.2 6.3 

Insecticides : 

Raw material 62.0 84.2 86.5 64.2 

Finished goods 0.5 1.1 5.0 1.4 

Packaging 1.5 1.2 2.1 0.4 

Containers 34.5 44.3 25.2 14.8 

Miscellaneous 14.5 13-9 8^ 48 

Total inventory $616.3 $624.8 $258.0 $393.9 



Megaphytic Products Company 

Exhibit 4 

MEGAPHYTIC PRODUCTS COMPANY 

Income Statement for Fiscal Year 1948 

(Dollar figures in thousands) 

Gross sales: 

Fertilizers $1,544 

Inseaicides 549 

Miscellaneous 118 

Total sales 

Less: Sales discounts $ 129 

Quantity discounts 21 

Commissions 4 

Consignment account expense 60 

Net sales 

Cost of sales: 

Inventory — beginning of year $ 452 

Purchases 1,401 

Total 

Less: Inventory — end of year 

Material consumed in sales 

Direct labor 

Manufacturing expense* 

Total cost of sales 

Gross profit on sales 

Selling expenses: 

Freight and trucking 

Selling and shipping 

Total selling expenses 

Administrative expense* 

Operating profit 

Other income: 

Discounts on purchases 

Interest received 

Rents received 

Recoveries of bad debts 

Sale of scrap and miscellaneous 

Profit on assets sold 

Total other income 

Other deduaions: 

Interest paid 

Pensions paid 

Contribution to pension trust 

Net income for year 

Provision for federal income tax 

Net profit for year 

* Includes $20, depreciation. 



27 



$2,211 



214 



$1,997 



$1,853 
394 




$1,459 

33 

103 






1,595 




$ 402 


$ 105 
114 






219 




$ 183 
84 



$ 99 



24 



$ 123 



12 




17 




$ 


106 
40 




$_ 


66 



IVVVVVVVVVVWVVVVVVVVVVWVVVVVVVVVVVI*VVV\VVV\\\VVVVVVVVV^^ 



Clarkson Lumber Company 



i\A^VVVV\VVVWAVVVVVW^\\VVVVWVV\VVVVVVVW^VVVVVVV>M\\VW 



Following a rapid growth in its business during recent years, the 
Clarkson Lumber Company in the spring of 1940 anticipated a further 
substantial increase in sales. Despite good profits, which were largely 
retained in the business, the company had experienced a shortage of cash 
and had found it necessary to borrow $48,000 from the Suburban 
National Bank. In the spring of 1940, additional borrowing seemed 
necessary if sales were to be increased and purchase discounts taken. 
Since $48,000 was the maximum amount which the Suburban National 
would lend to any borrower, it was necessary for Mr. Paul Clarkson, 
proprietor of the Clarkson Lumber Company, to look elsewhere for 
additional credit. 

Through a personal friend who was well acquainted with one of the 
officers of a large metropolitan bank, the Northrup National Bank, 
Mr. Clarkson obtained an introduction to the officer and presented a 
request for an additional bank loan of $80,000. Consequently, the credit 
department of the Northrup National Bank made its usual investigation 
of the company for the information of the loan officers of the bank. 

The Clarkson Lumber Company was founded in 1930 as a partner- 
ship of Mr. Clarkson and Mr. Henry Stark, a brother-in-law of Mr. 
Clarkson. Six years later Mr. Clarkson bought out Mr. Stark's interest 
and continued the business as sole proprietor. 

The business was located in a suburb of a large mid western city. 
Land and a siding were leased from a railroad. Two portable sheet 
metal storage buildings had been erected by the company. Operations 
were limited to the wholesale distribution of plywood, moldings, and 
sash and door products to lumber dealers in the local area. Credit terms 
of net 30 days and net 60 days on open account were usually offered 
customers. 

28 



Clarkson Lumber Company 29 

Sales volume had been built up largely on the basis of successful 
price competition made possible through careful control of operating 
expenses and by quantity purchases of materials at substantial discounts. 
Almost all of the moldings and sash and door products, which 
amounted to 40% and 20% of sales, respectively, were used for repair 
work. About 55% of total sales were made in the six months from 
March through August. No sales representatives were employed, orders 
being taken exclusively over the telephone. Annual sales of $313,646 
in 1935 and of $476,275 in 1936 gave net profits of $32,494 and of 
$34,131, respectively. Comparative operating statements for the years 
1937 through 1939 and for the three months ending March 31, 1940, 
are given in Exhibit 1. 

Mr. Clarkson was an energetic man, 39 years of age, who worked 
long hours on the job, not only handling management matters but also 
performing a large amount of the clerical work. Help was afforded by 
an assistant who, in the words of the investigator of the Northrup Na- 
tional Bank, "has been doing and can do about everything that Mr. 
Clarkson does in the organization." 

Other employees numbered 14, of whom 1 1 worked in the yard and 
3 drove trucks. Mr. Clarkson had adopted the practice of paying union 
dues and all social security taxes for his employees; in addition, bonuses 
were distributed to them at the end of each year. In 1939 the bonus 
amounted to 40% of annual wages. Mr. Clarkson was planning to 
incorporate the business in the near future and to sell stock to certain 
employees. 

As a part of its customary investigation of prospective borrowers, the 
Northrup National Bank sent inquiries concerning Mr. Clarkson to a 
number of firms which had business dealings with him. The manager 
of one of his large suppliers, the Barker Company, wrote in answer: 

The conservative operation of his business appeals to us. He has not wasted 
his money in disproportionate plant investment. His operating expenses are as 
low as they could possibly be. He has personal control over every feature of his 
business and he possesses sound judgment and a willingness to work harder than 
anyone I have ever known. This with a good personality, gives him an excellent 
turnover and from my personal experience in watching him work, I know that 
he keeps close check on his own credits. 

All of the other trade letters received by the bank bore out the state- 
ments quoted above. 

In addition to the ownership of his lumber business, Mr. Clarkson 



30 



Case Problems in Finance 



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31 



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32 Case Problems in Finance 

held jointly with his wife an equity in their home, which was mortgaged 
for $12,000 and which cost $20,160 to build in 1927. He also held a 
$16,000 life insurance policy, payable to Mrs. Clarkson. Mrs. Clarkson 
owned independently a half-interest in a home worth about $8,000. 

The bank gave particular attention to the debt position and current 
ratio of the business. It noted the ready market for the company's prod- 
ucts at all times and the fact that sales prospects were particularly favora- 
ble. The bank's investigator reported: '\ . . it is estimated sales may 
run from $1,280,000 to $1,600,000 in 1940." The rate of inventory 
turnover was high, and losses on bad debts in past years had been quite 
small. Comparative balance sheets as of December 31, 1937, through 
1939 and as of March 31, 1940, are given in Exhibit 2 (p. 31). 

The bank learned, through inquiry of another wholesale lumber 
company, that the usual terms of purchase in the trade were 2%, 10 
days after arrival. Suppliers took 60-day notes when requested but did 
this somewhat unwillingly. 



1\>\V\AVWVVVVVVWVVVVVWVVVVVVV\AA\V\AA^VVVAAAAAAVV^^ 



Tremblant Manufacturing Company 



^VVVVVVVVVVVVVVVWVVVVVVVVVV\VVVVVVWVVVV\A\VVVVVVVVWVA^VVVVV^^ 



In October, 1947, Mr. James T. Hill, treasurer of the Tremblant 
Manufacturing Company, requested an additional loan of $150,000 
from the Idlewild National Bank in order to make a rearrangement of 
production facilities for laborsaving and greater economy in operation. 
This was in addition to a loan of $350,000 for new plant equipment and 
working capital which the bank had made in July, 1947. 

The Tremblant Manufacturing Company fabricated aluminum nov- 
elty items, such as curlers, small trays, small boxes, etc., for the chain- 
store trade and larger aluminum trays for the restaurant industry. Dur- 
ing 1945 the company embarked on a program to roll aluminum foil 
with colored patterns and designs embossed or printed thereon. This 
product was to be used for packaging, and it met with an enthusiastic 
market. 

The bank's files on the company indicated that it had commenced 
business in 1929 with a small capital investment. A group of small 
factory buildings had been purchased in Cincinnati, Ohio, at a nominal 
figure, but considerable amounts had been spent from time to time in 
renovating them. Operations at first were relatively simple but became 
more complex as conditions changed, especially with the advent of the 
war. Late in the war the company entered the aluminum foil business. 

Before the war this type of foil had been made exclusively in Europe, 
where the processes were secret. However, the president of the company, 
Mr. A. N. Trembley, through connections in France had learned a little 
of the general nature of the technique, which, when coupled with meth- 
ods of treating aluminum developed in the United States during the war, 
enabled the company to evolve a technique for embossing and coloring 
aluminum foil during the rolling operations. 

The Idlewild National Bank had received from time to time favora- 
ble reports regarding the company and its personnel from other banks, 

33 



34 Case Problems in Finance 

from suppliers of Tremblant, and from credit agencies. Mr. Trembley 
was described as '\ . . one of the ablest men in the business. He has 
been very successful and is a hard competitor." Another source de- 
scribed the concern as ". . . a wonderful outfit. They are very aggres- 
sive, very capable, and have made a pronounced success of their business. 
James Hill, the treasurer, has his feet solidly on the ground. He watches 
over the company's affairs with the utmost precision." One source re- 
ported a situation some time before the war when Japanese competition 
seriously threatened the Tremblant company's business. The company 
soon met this competition by developing methods which enabled it to 
undersell the Japanese in spite of their lower labor costs. 

The Idlewild National Bank learned from credit agencies that the 
company purchased on 30-day terms. None of its principal suppliers 
indicated any slowness in payment. The bank did not know what terms 
the company extended to its customers, although it did know that credit 
insurance was carried on its accounts receivable. 

Mr. Eddy's predecessor as senior loan officer of the bank, after a visit 
to the plant in Cincinnati on August 10, 1947, made this report: 

They believe that the field for their products at the moment is almost un- 
limited. The factory appears very neat, and extensive mechanization makes labor 
a comparatively unimportant factor in costs. The plant is unionized, but they 
consider their relations with their employees reasonably satisfactory. They 
employ from 530 to 620 people depending on trade conditions. The greater 
number of employees seem to be employed in the inspection, packing and 
shipping departments. They maintain a research laboratory which is, in itself, a 
small pilot plant. The executives with whom I talked created a favorable im- 
pression. They are hard workers, and are keenly interested in the company. 

In July, 1947, the company secured a loan from the Idlewild Na- 
tional Bank consisting essentially of two parts: 

1. A loan of $270,000 at 4% interest to be repaid in 27 equal 
monthly payments commencing February, 1948. This loan was to be 
used to purchase precision rollers and presses. These presses were to be 
the largest of their kind in the United States and would turn out amounts 
of foil much in excess of orders on hand. The company felt that it 
would experience no difficulty in disposing of these large amounts of 
foil once it could promise reasonable delivery and continuity of supply. 
The managment indicated at this time that after the completion of this 
project no further expansion was contemplated for five years at least. 



Tremblant Manufacturing Company 35 

2. A loan of $80,000 for working capital. This loan was a renewal 
of one of the same amount granted previously and under the new ar- 
rangements would mature on July 15, 1948. 

In October, 1947, Mr. Trembley and Mr. Hill called on Mr. Frank 
Eddy, the new senior loan officer of the bank, to explore the possibilities 
of securing an additional loan of $150,000, which was to be used to 
make a rearrangement of facilities to effect economies in labor, etc., 
rather than to obtain increased production. This plan had been 
planned before and held in abeyance, but the company's line of foils had 
been so well received that it was felt that it would be advantageous to 
include this additional expenditure in the present program. 

Inasmuch as Mr. Eddy had just recently assumed responsibility for 
the Tremblant account and was not familiar with the company's past 
methods of financing and handling of its funds, he felt he should first 
make a comprehensive study of the financial statements in his files, as 
shown in Exhibits 1,2, and 3, and thus be able to discuss with the other 
officers of the bank the advisability of making this loan. 



36 



Case Problems in Finance 






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37 
















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38 



Case Problems in Finance 



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VVVVVV^V\\VV^VVVVA A/VVVVVVVVVVV^VVVW\\\VW\AAAA^\Vi^VVV\\^^ 

United American Manufacturing 
Company' 

MAAAA^VVVVVVVV\VVVVMAVVVVVVVVV\M\VV\VWV^VV>A\VVVVVVVV^^ 



Early in March, 1949, the president of the United American Man- 
ufacturing Company asked the treasurer of the company, Mr. J. Q. 
PubHcan, to prepare a brief talk for presentation at the annual meeting 
of the stockholders of the company to be held approximately in two 
weeks. Condensed income statements and balance sheets for each quarter 
of the last two years, as shown in Exhibits 1 and 2, would be distributed 
at the stockholders' meeting. The president asked Mr. Publican to pre- 
pare to explain in simple terms the present financial condition of the 
company and to point out any significant changes in the company's finan- 
cial condition as revealed by either the profit and loss statements or the 
balance sheet. He emphasized that, since many of the stockholders would 
not have a very good understanding of financial matters, it was essential 
that the remarks be accurate but stated in simple language and straight- 
forward terms readily understandable by all persons. 

^ The material in this case is from various published sources. 



39 



40 



Case Problems in Finance 



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United American Manufacturing Company 



41 



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Monroe Department Store 



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In the late spring of 1948, the officers of the Monroe Department 
Store in Rochester, New York, began to consider the advisability of 
opening a branch store in Batavia, a city of about 20,000 population, lo- 
cated about 30 miles toward Buffalo. Preliminary investigation indi- 
cated that a branch in Batavia might enjoy a sales volume of about 
$1,000,000 a year. 

Local interests had offered space for the branch to the Monroe com- 
pany, in a new building fully equipped, centrally located, and on satis- 
factory rental terms. 

Early in the consideration of this possibility, the officers took up 
questions of the financial requirements of the branch and the financial 
position of the Monroe company with reference to the requirements. 
After a little discussion it was decided to obtain some estimates to see 
if the project was within the financial capacity of the company. Accord- 
ingly, the controller of the company asked Mr. Arthur Gold, an em- 
ployee in his department, to study the available information about 
typical stores and to compute approximate figures. Mr. Gold was told 
that there were two objectives. The first was to estimate the needed 
investment in working capital for the branch. The second was to see 
if this amount of funds could be provided by the Monroe company, 
without weakening its position to an undesirable extent. 

Since no detailed plans for the branch were available, Mr. Gold 
determined to accumulate information about "typical" stores to guide 
his calculations. After several hours of search, Mr. Gold had on his desk 
the material presented in Exhibits 1, 2, and 3. He was satisfied that 
little more information of the same nature could be collected. In fact, 
he felt that he had perhaps collected more than he could use. 



12 



Monroe Department Store 43 

Exhibit 1 

MONROE DEPARTMENT STORE 

Internal Data 

(Dollar figures in thousands) 

Balance Sheet, at January 31, 1948 

ASSETS 

Cash $ 1,526 

U.S. bonds 825 

Accounts receivable, net 1,793 

Inventory, at cost 2,073 

Current assets $ 6,2 17 

Fixed assets, net • 3,074 

Deferred charges 67 

Other assets 36 

$ 9,394 



LIABILITIES 

Accounts payable $ 886 

Accrued taxes 903 

Current liabilities $ 1,789 

Reserves 856 

Common stock 2,900 

Earned surplus 3,849 

$ 9,394 

Earnings, Year Ended January 31, 1948 
Net sales $15,141 

Cost of sales 8,357 

Expenses 4.970 

Operating profit $ 1,8 14 

Income from broadcasting station 259 

Profit before income tax $ 2,073 

Estiinated income taxes 800 

Net profit $ 1,273 

Added to reserves 300 

Balance $ 973 

Other Data (as Reported to Harvard Bureau)* 

Stock turn, based on beginning and ending inventories at cost 4.7 

Inventory, end of period, as % net sales 13.7 

* See Exhibit 2. 



44 Case Problems in Finance 

Exhibit 2 
MONROE DEPARTMENT STORE 

Selected Statistical Data from 1947 Issue of 

Operating Results of Department and Specialty Stores 

Harvard Bureau of Business Research, 1948 

Table 4 

Common Figures* for Merchandising Operations and Profits 



Annual Sales 


Net 
Sales 


Gross 
Margin 


Net 
Profit 


Stock 
Turnt 


$10,000,000-$20 000 000 


100.0% 
100.0 


35.6% 
34.5 


4.9% 
6.5 


5 1 


1,000,000- 2,000,000 


4.9 







* a "common figure," by Bureau definition, is a representative result selected for each individual item. It is in- 
tended to reflect a typical performance from the stores studied, 
t Based on beginning and ending inventories at cost: 

Cost of Sales 



5 (Beginning Inv. + Ending Inv.) 

Table 11 
Common Figures for Credit Data 



Annual Sales 


Net 
Sales 


Cash 


Credit 


Average Accounts 

Receivable, as % 

Credit Sales 

for Year 


$10,000,000-$20,000,000 


100.0% 
100.0 


50.0% 
57.0 


50.0% 
43.0 


20.0% 


1,000,000- 2 000 000 


15.0 







Table 14 
Supplementary Data According to Size of City 



Size of City 


Annual Sales 


Stock Turn* 


250,000-500,000 
15,000- 25,000 


$10,000,000-$20,000,000 
1,000,000- 2,000,000 


5.1 
5.3 



* Based on beginning and ending inventories at cost: 
Cost of Sales 



I (Beginning Inv. + Ending Inv.) 

Table 15 
Operating Results According to Form Approved by NRDGA 





Net 
Sales 


Inventory 


Operating 




Beginning 


Ending 


Income 


$10,(X)0,000-$20,000,000 


100.0% 
100.0 


12.1% 
13.4 


13.2% 
14.0 


4.9% 


1,000,000- 2,000,000 


6.5 







Monroe Department Store 



45 



Exhibit 2 — Continued 

Table 16 
Aggregate* Working Capital Position of 76 Department Stores 
WITH Sales of $10,000,000 or More at End of Fiscal Year: 1947 

Net salesf 100.0% 

Total current assets 29.6 

Net working capital 19.7 

Current assets: 

Cash and government securities! 17.8% 

Accounts receivable 38.9 

Merchandise inventories! 42.1 

Other 1.2 

Total 100.0% 

Current assets -^ Current liabilities 299.1% 

* Computed by totaling the dollar figures reported by the several stores. 

t Net sales of the 76 stores (owned departments only) amounted to $1,981,344,000 for the fiscal year 1947. 
j All tax notes have been considered as current assets rather than as deductions from current liabilities. 
§ Lower of cost or market, first-in first-out basis. 



Exhibit 3 

MONROE DEPARTMENT STORE 

Department Store Ratios Published by Dun & Bradstreet, Inc.* 

Based on Year-End Figures for 1947 





Upper 




Lower 


3-Year 




Quar- 




Quar- 


Aver- 


Unit 


tM 


Medianf 


tilef 


age 


Times 


4.50 


3.09 


2.37 


2.80 


% 


6.82 


4.22 


2.62 


4.17 


% 


22.80 


16.10 


9.10 


15.04 


% 


31.70 


22.60 


14.65 


22.57 


Times 


4.82 


3.86 


2.79 


3.43 


Times 


6.58 


5.09 


3.60 


4.97 


Times 


8.9 


6.9 


5.1 


7.6 


% 


6.2 


17.0 


37.2 


17.1 


% 


20.7 


32.2 


50.6 


36.7 


% 


41.2 


57.3 


63.3 


59.3 


% 


46.8 


72.4 


92.0 


63.5 


% 


43.9 


72.6 


98.4 


91.4 


% 


17.3 


28.4 


44.4 


41.8 



Current assets to current debt .... 

Net profits to net sales 

Net profits to tangible net worth . . 
Net profits to net working capital . 
Turnover of tangible net worth . . . 
Turnover of net working capital . . 

Net sales to inventory 

Fixed assets to tangible net worth . 
Current debt to tangible net worth . , 
Total debt to tangible net worth . 
Inventory to net working capital . . 

Current debt to inventory 

Funded debt to net working capital 

* These appear in Dun's Review, November, 1948, and in the booklet, "The Theory of Corporate Net 
Profits." Used here by permission of Dun & Bradstreet, Inc. 

t To obtain these figures, the ratios for the stores were arranged in order of size. The median ratio is 
the one at the middle of this series. The quartiles are the ratios that were halfway between the extremes 
and the median (or one-quarter of the way from each extreme). In each case the figure used is reached 
by counting the items, not by averaging the ratios. 



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Larabee Company 



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On January 6, 1947, Mr. John Larabee, the owner and manager of 
a small retail store specializing in children's clothing and accessories, 
was engaged in preparing a cash budget for the first six months of 1947. 
The budget was being prepared at the request of Mr. Wilbert Walker, 
an officer of the Security National Bank, where the Larabee Company 
maintained a deposit and borrowing account. Mr. Larabee had recently 
called on Mr. Walker to talk over his plans for the spring season and to 
make sure that the bank would continue to supply the necessary credit 
to meet the needs of the company. After reviewing the balance sheet of 
the company as of January 1, 1947, as shown in Exhibit 1, and dis- 
cussing Mr. Larabee's expectations as to purchases and sales of merchan- 
dise during the next six months, as shown in Exhibit 2, Mr. Walker 
expressed the opinion that it would be easier to visualize the company's 
probable needs for credit if Mr. Larabee would draw up a cash budget. 
In reply to Mr. Larabee's question as to just what he meant by "cash 
budget," Mr. Walker explained that what he had in mind was a state- 
ment of expected cash receipts and payments for each of the next six 
months. Mr. Larabee agreed to draw up such a statement and to return 
for further discussion based on the statement. 

Mr. Larabee had opened the store in the latter part of 1943. Since 
his personal capital had been limited, he had been forced to borrow 
heavily and to limit sales to a cash basis. Sales had expanded rapidly, 
with corresponding increases in investment in inventory. In 1946, net 
sales had amounted to $181,800, net profit before federal income taxes 
$17,158, and net profit after taxes $11,740. Since the store was not 
incorporated, the net profit was taxed as personal income. 

During the first three years of operation, Mr. Larabee had aimed 
at building a clientele of steady customers who would patronize the 
store because they expected good quality at a reasonable price and not 

46 



Larabee Company 47 

primarily because they were attracted by the promotion of special items 
at exceptionally low prices. As part of this program he eliminated price 
appeal from all his advertising and emphasized the quality and service 
to be obtained at Larabee's. His chief competition came from department 
stores and specialty stores which carried children's wear in addition to 
other apparel. Since these stores offered charge accounts to their cus- 
tomers, Mr. Larabee had decided that he must offer similar arrange- 
ments. Therefore, he decided to make allowance in his cash budget for 
the probable effect of offering 30-day open charge accounts. He esti- 
mated that if he offered 30-day open charge accounts to his customers 
5% of his sales would be charge sales in January, 10% in February, 
13% in March, 16% in April, 18% in May, and 20% in June. Accord- 
ing to department store figures in the Federal Reserve Bulletin for De- 
cember, 1946 (p. 1406) , the average ratio of collections during a month 
to accounts receivable at the beginning of the month had been approxi- 
mately 60% during the first 10 months of 1946. 

The usual terms for Larabee's purchases of merchandise were 8/10 
E.O.M.,^ and such terms could be applied to the $12,600 accounts pay- 
able shown on the January 1 balance sheet. The other accounts payable 
shown on the balance sheet represented various obligations other than 
the purchase of merchandise and were payable at face value in January. 
The "Notes payable — bank" were due February 1. The bank had been 
extending credit on 30-day notes at 6% annual interest and renewing 
them as necessary. Mr. Larabee expected this practice would be con- 
tinued. 

The social security and withholding taxes of $412 were due in 
January. 

Mr. Larabee had estimated his 1946 income tax at $100 and had 
paid three quarterly installments of $25 each on March 15, June 15, and 
September 15, 1946. Another $25 installment was due on January 15. 
On January 1, 1947, he estimated his final tax for 1946 at $5,418. 
Therefore the amount payable on March 15 would be $5,418 less $100. 
Currently, Mr. Larabee estimated his quarterly payments for 1947 in- 
come tax at $1,350. Two of these would be paid on March 15 and 
June 15. 

Mr. Larabee's merchandise plans for the spring season had been 
made on the assumption that all sales would be made for cash. Although 
he believed that offering charge accounts might bring about a greater 

-■•The terms "8/10 E.O.M." meant that an 8% cash discount would be allowed for 
payment within 10 days after the end of the month in which the invoice was dated. 



48 



Case Problems in Finance 



Exhibit 1 
LARABEE COMPANY 

Balance Sheet 
As of January 1, 1947 
ASSETS 
Current assets'. 

Cash $ 4,930 

Deposits for utilities 105 

Inventory, December 31, 1946, at cost 37,143 

Total current assets $42,178 

Vixed assets: 

Fixtures and equipment $ 3,268 

Automobile 1,328 

Total fixed assets 4,796 

Total assets $46,974 

LIABILITIES 

Current liabilities : 

Accounts payable — merchandise, at billed cost $12,600 

Other accounts payable 820 

Social security and withholding tax 412 

Notes payable — bank 3,750 

Income tax for 1946* 5,343 

Total current liabilities $22,925 

Net worth as of January 1, 1946 $17,033 

Profit for period 11,740 

$28,773 

Withdrawals 4,724 

Net worth as of January 1, 1947 24,049 

Total liabilities $46,974 

• Due March 15, 1947, except for $25 due January 15. 



Exhibit 2 

LARABEE COMPANY 

Planned Purchases and Sales of Merchandise 



Planned 
Sales 

January , . $ 9,500 

February 12,000 

March 22,000 

April 17,000 

May 17,000 

June 13,500 

$91,000 



Planned 
Purchases 
at Billed 

Cost 

% 3,821 

15,925 

13,325 

9,555 

7,020 

6,175 

$55,821 



Larabee Company 49 

increase in sales than the 20% planned in the budget, he believed that 
the magnitude of the increase was so uncertain as to make it unwise to 
increase his budget. Among the important factors considered in the 
preparation of the merchandise budget was the fact that Easter fell on 
April 6 in 1947. Mr. Larabee's contemplated purchases and his esti- 
mated sales through June are shown in Exhibit 2. 

Since Mr. Larabee had all his money invested in the business, he 
found it necessary to withdraw cash for his personal use each month. He 
estimated that these withdrawals would be approximately $350 per 
month during the first six months of 1947. 

Mr. Larabee had made a table of expenditures as shown in Exhibit 3. 
This budget included certain items calling for cash outlay during the 
period. Included in the various breakdowns of outlay for January were 
the amounts shown on the January 1 balance sheet as "Other accounts 
payable" and "Social security and withholding tax." The expense budget 
did nof include anticipated income tax payments, Mr. Larabee's with- 
drawals, or anticipated payments for merchandise. 

In view of the difficulty of estimating accurately the small amount 
that would be paid the bank as interest, the banker, Mr. Walker, had 
suggested that the outlay for bank interest not be included in the 
calculations. Mr. Larabee planned to accept this suggestion. All other 
foreseeable outlays as indicated would be included. 



Exhibit 5 

larabee company 

Partial Cash Disbursement Budget for Period Ending June 30, 1947 

Jan. Feb. Mar. April May June Total 

Payroll $1,400 $1,600 $2,000 $1,800 $1,800 $1,600 $10,200 

Rent 400 400 400 400 400 400 2,400 

Advertising . . 150 400 800 600 600 400 2,950 

Supplies 150 200 350 250 200 150 1,300 

Other 700 600 800 700 700 500 4,000 

Total ...$2,800 $3;200 $4,350 $3,750 $3,700 $3,050 $20,850 



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Linwood Company 



i\WVVVVAAAVVVWWl^AA(WVV\\VVVWVVVVVVAAAVVVVVVVVVVVVWWVVVV^^ 



Early in April, 1941, the Linwood Company submitted an audited 
financial statement to the Third National Bank of its city. This state- 
ment showed the results of operations for the first three months of the 
year. It was observed that, despite greatly increased volume of sales 
due to war orders, the company had lost more heavily in this period than 
in the year 1940. Figures from the reports covering both periods will 
be found in Exhibits 1 through 3. Since the bank had already loaned the 
company $325,000 and anticipated being asked to advance further 
funds, it was decided to make a further investigation of the situation. 

The Linwood Company manufactured a patented air filter for auto- 
motive engines. Never outstandingly profitable, the company had suf- 
fered heavy losses in recent years. Competent engineers had pronounced 
the company's air filter to be a sound device, but its high price had 
limited the market to those who operated trucks under extremely 
dusty conditions. However, in 1940 very large orders were received 
from the Army, so that in October the company's leased plant was 
operating at capacity and new equipment, to be partly financed by gov- 
ernment funds, was being installed. 

After receiving the statements shown in Exhibits 1 through 3, the 
credit department of the Third National Bank wrote the treasurer of the 
Linwood Company asking for a cash budget to cover the three months 
from April 1. A prompt reply was received, containing the figures shown 
in Exhibit 4. The treasurer's letter stated that the estimate was the best 
possible at the time and that it was based on existing production sched- 
ules. The unfilled orders on the books at the beginning of April were 
$780,101.73, almost entirely from the Army. The treasurer stated that, 
in making the budget, he had tried to err on the conservative side and 
pointed out that, in view of the indicated cash losses, further loans from 
the bank would be required. In response to another inquiry in the bank's 

50 



LiNwooD Company 51 

letter, the treasurer stated that it normally took three weeks for the 
handling of the product from raw material to shipment. 

After examining the figures submitted by the Linwood Company, 
which seemed to him to leave several gaps, the manager of the credit 
department turned the material over to Mr. Johnson, one of his assist- 
ants, and asked him to prepare for a trip to the offices of the company, 
where an interview with the treasurer would be arranged. If properly 
conducted, such an interview would provide information necessary for 
a decision about further loans. 



52 



Case Problems in Finance 



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54 



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Trivett Manufacturing Company (A) 



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In July, 1946, Eldon Brigham, treasurer of the Trivett Manufactur- 
ing Company, was reviewing his working capital position. It was his 
custom to calculate working capital needs for the next six months in 
January and July of each year and to formulate plans for meeting such 
needs. 

The Trivett Manufacturing Company, which had been founded in 
1934, operated a small machine shop in a Philadelphia suburb. The 
company had originally manufactured lapping plates and made gauges 
and special tools on order. In 1941 a newly designed industrial stapling 
machine was added to its line. 

Operating losses and poor financial management had kept the com- 
pany in financial difficulty during the greater part of its early history. 
Matters were made worse by a conflict which developed between the 
common and preferred stockholders. Inability of these two groups to 
agree had prevented the taking of corrective measures. 

In the spring of 1942 this situation came to the attention of Mr. 
Brigham, a businessman who specialized in rehabilitating financially 
weak concerns. He analyzed the company and found that it had in its 
employ a number of skilled machinists and possessed good equipment 
suitable for precision work. Mr. Brigham was also impressed by postwar 
prospects for the company's stapling machine, which was far superior to 
competitive products. As a result of his analysis Mr. Brigham concluded 
that with competent management the company could be operated profit- 
ably. The two stockholding groups were approached, and an agreement 
worked out whereby Mr. Brigham became, in effect, head of the com- 
pany. For his efforts he was to receive a fixed salary plus a percentage of 
profits. Mr. Brigham, who was an officer of a number of other concerns, 
was to devote only part of his time to the Trivett Manufacturing Com- 
pany. 

56 



Trivett Manufacturing Company (A) 57 

During the war Mr. Brigham concentrated on obtaining fixed fee 
Army contracts for the manufacture of precision instruments. Because 
of rigid economies which he instituted these contracts proved highly 
profitable, even after renegotiation. Wartime profits and Mr. Brigham's 
skillful financial management soon rehabilitated the company. By the 
end of 1944 the deficit accumulated during many years of unprofitable 
operations had been eliminated. 

The ending of hostilities in August, 1945, brought cancellation of 
the company's Army contracts. Mr. Brigham immediately took steps 
to curtail overhead and administrative expenses, but he retained the 
company's skilled machinists. 

Sales and production efforts were concentrated on the industrial 
stapling machine. Prewar prices on the company's lapping plates had 
been about 50% less than for standard makes. As a result, the prices 
which the OPA would permit the company to charge currently were 
set at a level that Mr. Brigham considered too low. Until a better price 
could be obtained he did not intend to manufacture plates. Furthermore, 
since there was sharp price competition for gauge and tool work in the 
locality after V-J Day, Mr. Brigham decided that no effort should be 
made to seek this type of business for the time being. 

Demand for the stapling machines was good. Monthly shipments 
during the first half of 1946 averaged about 75 units priced at $200 
each. More units could have been sold and shipped, but Mr. Brigham 
did not wish to risk overextending the company while conditions were 
so unsettled. 

Balance sheets and operating statements for 1944, 1945, and the 
first six months of 1946 are shown in Exhibits 1 and 2 (pp. 60-61). 

Early in May an invitation was received to bid on an Army contract 
for the manufacture of 301 gun sights. Mr. Brigham thought that a 
good profit could be made on the sights, and so he decided to submit 
a bid. His first bid of $720 a unit was rejected, but a second bid of $615 
was accepted. One "pilot" sight was to be produced during August for 
the purpose of testing design and production methods. It was to be 
retained at the plant but invoiced on September 1 at $615. This experi- 
mental unit was to be manufactured from materials on hand. Direct 
labor for this model was estimated at $500. The lessons learned during 
the making of the first unit were expected to enable the company to start 
gun sight produaion at full scale about September 1. Production was 
expected to be maintained at a fairly constant rate until November 30. 



58 Case Problems in Finance 

Delivery of the sights was to start the first week in October and was to 
be made at the rate of 100 units a month during October, November, 
and December. 

Estimated per unit direct costs of producing the gun sight were as 
follows: labor, $242; material, $128. 

In addition to the estimated direct labor cost of $242 per unit, Mr. 
Brigham estimated that the build-up of the additional labor force needed 
for gun sight production would require $2,500 in extra wage expense 
during August. Similarly, $3,000 of additional wage expense was 
budgeted for December so as to permit less abrupt reduction of the work 
force upon completion of the contract. Virtually all of the $3,000 
would be paid out in the first three weeks of December. 

To insure against delays in delivery, Mr. Brigham intended to keep 
a minimum of one month's supply of raw material for the gun sight on 
hand at all times during the production period. Work-in-process inven- 
tory for gun sight production was expected to average $20,000 during 
the period of full-scale production. The great majority of the company's 
purchases were made on terms of net/30, and invoices were paid 
promptly when due. Wages were paid every Friday.^ The production 
process from raw material to finished product was estimated to take 
a month. The Army would accept shipments in lots of 25 units, and 
payment would be received about 60 days after shipment. 

Estimated per unit direct costs of producing the stapling machine 
were as follows: materials, $40; labor, $36. A minimum inventory of a 
three months' supply of raw material was currently considered necessary 
because of unsettled conditions. Work-in-process inventory for stapling 
machine production was expected to continue at the present level. All 
current inventory was usable. The length of the production process was 
four weeks. Units were shipped as soon as produced, and terms of sale 
were net/30. The company had a backlog of orders for 350 machines. 
Production and shipments, however, were expected to continue at the 
rate of about 75 units a month through the first quarter of 1947. 

Monthly indirect expenses were currently running as follows: de- 
preciation, $540; other factory overhead, $3,500; . administration, 
$2,350. Tooling for the gun sight contract started in July. During July 
and August tooling expenses and experimental manufacture of the 
pilot gun sight were expected to increase factory overhead by about 
$1,200 a month. Starting in September, when full-scale production of 

^ There were four paydays in July, five in August, four in each of September and 
October, five in November, and four in December. 



Trivett Manufacturing Company (A) 59 

the gun sight was to begin, factory overhead was expected to become 
about $4,500 a month until the end of November. Administration ex- 
pense was expected to increase to about $3,000 a month from Septem- 
ber 1 to the end of December. 

The Army contract had made necessary the purchase of $2,000 of 
special tools. Delivery of these tools was expected in August; payment 
terms were C.O.D. Upon completion of the contract these tools would 
be scrapped. An additional $5,000 might also have to be spent for the 
replacement of old machinery which appeared to be nearing the end 
of its useful life. There was no way of knowing, however, when this 
machinery would finally break down. Mr. Brigham was confident that 
he could find replacements within a few days in the event of an emer- 
gency. The machinery to be retired was fully depreciated. 

Mr. Brigham worked out a tentative purchase schedule for the 
various material requirements. The schedule is reproduced as Exhibit 3. 
It shows the amounts of purchases in the months that they were ex- 
pected to be booked. 

The company maintained a small deposit account with a local bank 
and kept the remainder of its cash in an account with the Fourth Na- 
tional Bank of Philadelphia. The company had originally banked with 
the Farmers and Merchants Bank, a small local institution, from which 
it had borrowed from time to time during the war to help finance pro- 
duction on government contracts. Toward the end of the war, however, 
Mr. Brigham sensed that Mr. Appleseed, the bank's president, was be- 
coming apprehensive about lending money to the company. Mr. Brig- 
ham attributed this reluctance to the fact that Mr. Appleseed had had 
little experience in lending money to industrial concerns; the greater 
portion of the bank's commercial loans were to local storekeepers. 
Therefore, Mr. Brigham withdrew his account from the bank. A small 
account was opened at another local bank, and the remainder of the 
company's funds were deposited with the Fourth National Bank of 
Philadelphia, a medium-sized bank with a legal loan limit of $150,000. 
Mr. Brigham had discussed the company's prospects in general terms 
with the bank's officers on a number of occasions, but he had never re- 
quested a loan. 

Mr. Brigham considered his current cash balance of almost $28,000 
to be in excess of operating needs. He was willing to reduce cash to a 
minimum of $5,000. No dividend payments were scheduled for the 
remainder of 1946. 

It was Mr. Brigham's policy not to plan more than six months in 



60 Case Problems in Finance 

advance, since he believed that it was impossible to predict with any 
accuracy what was going to happen for a longer period. The company's 

plans for the first half of 1947 would be made in the light of conditions 

as they developed and of the company's prospective financial condition 
at the end of 1946. 

Exhibit 1 

TRIVETT MANUFACTURING COMPANY 

Balance Sheets 

Dec. 51, Dec. 31, June 30, 

ASSETS 1944 1943 1946 
Current assets'. 

Cash $ 12,982 $ 16,066 $27,753 

Accounts receivable, net 48,107 29,583 19,593 

Inventory 45,514 34,016 

Raw material 13,134 

Work in process 6,636 

Prepaid items 725 1,179 325 

Total current assets $107,328 $ 80,844 $67,441 

Fixed assets: 

Property account $ 46,507 $ 47,153 $47,776 

Less: Reserve for depreciation 14,534 19,916 21,057 

Property account, net $ 31,973 $ 27,237 $26,719 

Total assets $139,301 $108,081 $94,160 

LIABILITIES AND CAPITAL 

Current liabilities : 

Accounts payable $ 27,668 $ 17,338 $ 9,066 

Accrued liabilities 9,592 1,836 4,777 

Reserve for previous year's federal taxes 8,172 4,891 12,095* 

Reserve for current year's federal taxes 8,451 24,649 4,486t 

Accrued taxes 6,381 2,736 1,812* 

Total current liabilities $ 60,264 $ 51,450 $32,236 

Fixed liabilities : 

Due officers 13,834 

Due U.S. government on contract advances . . 21,996 

Capital'. 

Preferred stock, 6% 21,000 21,000 21,000 

Common stock, $100 par 17,000 17,000 17,000 

Surplus 5,207 18,631 23,924 

Total liabilities and capital $139,301 $108,081 $94,160 

* Payable in equal installments, September 15 and December 15, 1946. 

t Payable in equal installments, March 15, June 15, September 15, and December 15, 1947. 



Year 
1943 


6 Months 

Ending 

June 30, 

1946 


$331,575* 


$86,966 


$ 97,065 

85,758 

5,382 

47,940 


$21,680 

15,279 

3,242 

20,514 



Trivett Manufacturing Company (A) 61 

Exhibit 2 

TRIVETT manufacturing COMPANY 

Operating Statements 



Year 
1944 

Sales, net $282,888 * 

Cost of sales: 

Material $ 36,548 

Direa labor 1 16,366 

Depreciation 6,515 

Faaory overhead 52,842 

Gross profit $ 70,617 $ 95,430 $26,251 

Less: Administration expense: 

Shipping expense $ 9,561 $ 5,886 $ 235 

Selling expense 10,442 7,480 

Other expense 31.533 43,300 14,775 

Net operating profit $ 19,081 $ 38,764 $11,241 

Other charges 308 521 

Net gain before federal taxes $ 18,773 $ 38,243 $11,241 

Less: Federal taxes 8,450 24,183 4,486 

Net profit . $ 10,323 $ 14,060 $ 6,755 

* After adjustment for renegotiation. 

Exhibit 3 

TRIVETT MANUFACTURING COMPANY 

Tentative Schedule of Purchases 

July-December, 1946 

July Aug. Sept. Oct. Nov. Dec. 

Raw material— stapler $ 1,994 $ 3,000 $ 3,000 $3,000 $3,000 

Raw material— gun sight 12,800 12,800 12,800 

Special tools — gun sight 2,000 

Total $16,794 $15,800 $15,800 $3,000 $3,000 

Replacement machinery . . .$5,000 (uncertain date) 



V\\VV\VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV\AA\VWVVVV^^ 



Trivett Manufacturing Company (B) 



VV\VV\VVVVVVVV\V\VVVVVVVVVVVVVVVAaVVl\VVV\VV\A\VVVV\\VWV^^ 



In July of 1946, Mr. Lyman Huffman, a vice-president and loaning 
officer of a medium-sized Philadelphia bank, the Fourth National Bank, 
had a visit from Mr. Eldon Brigham, treasurer of the Trivett Manu- 
facturing Company. Mr. Brigham explained that his firm had recently 
received a contract for the manufacture of 300 gun sights for the U.S. 
Army. The contract was to be completed within six months, and the 
work on the contract would be in addition to the company's regular pro- 
duction of a line of stapling machines. 

According to a projected income statement for the next six months, 
which Mr. Brigham brought with him, the contract promised to be very 
profitable. However, much additional working capital would be needed 
to finance the operations of the company during the period. Speaking 
from a schedule of anticipated cash receipts and expenditures for each of 
the last six months of 1946, Mr. Brigham explained that according to 
his estimates as much as $100,000 might be required to complete the 
order as planned. Such a large loan would be required for only a brief 
time, Mr. Brigham felt. As work on the order was completed and pay- 
ments began to come in from the Army, the company's cash position 
would improve and repayment of the loan could begin. Mr. Brigham 
estimated that repayment could be completed by the end of February, 
1947. 

Since money was not needed at once, Mr. Brigham asked that the 
company be granted a line of credit under which the company could 
borrow as needed up to $100,000 on short-term notes. 

After looking over the June 30 balance sheet of the company, Mr. 
Huffman observed that $100,000 was a very large loan for a small com- 
pany. Mr. Brigham seemed somewhat annoyed at this comment and 
replied that he thought this was just the kind of self-liquidating loan 
proposition that commercial banks liked. He added that he had recently 

62 



Trivett Manufacturing Company (B) 63 

been approached by a finance company which would be very happy to 
have this business. Mr. Huffman quickly stated that the Fourth National 
Bank had always held the reputation of being a progressive bank, and 
that the bank was definitely interested in Mr. Brigham's request. On 
the other hand, he felt that the bank owed a real obligation to its many 
depositors to protect their funds. Accordingly, he asked Mr. Brigham to 
leave with him the pro forma statements and cash budget he had pre- 
pared, so that he and other members of the bank's loan committee could 
study the proposal. He promised that Mr. Brigham would hear from him 
within a few days. After a brief discussion, Mr. Brigham asked Mr. Huff- 
man to telephone him if the material raised any questions which he 
might answer. 

Mr. Huffman was somewhat familiar with the affairs of the Trivett 
Manufacturing Company since he had talked about the company in gen- 
eral terms with Mr. Brigham on several occasions after the company had 
opened a deposit account something more than a year before. He had 
formed a rather favorable impression of Mr. Brigham and the company, 
and a review of the brief file that had been built up on the company in- 
dicated that it paid its bills promptly and enjoyed a good reputation in 
trade circles. 

Mr. Huffman's responsibilities as the loaning officer responsible for 
the Trivett account included: all necessary analysis and investigation of 
the credit; decision on the terms of a loan, including collateral, maturity, 
and interest; and oral presentation of his recommendations before the 
bank's loan committee. This group, made up of senior officers, sometimes 
reviewed a proposal thoroughly through their questioning and dis- 
cussion. 



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Harbin Company 



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On July 30, 1946, the officers' loan committee of the Fifth National 
Bank of Philadelphia was scheduled to vote on a proposed loan to the 
Harbin Company. The Fifth National Bank was a relatively moderate- 
sized bank, with a legal loan limit of $190,000. The bank's staff was 
small but highly efficient. Its loan officers had a reputation for imagina- 
tion and initiative and often tried to work out loans in situations which 
most of its competitors would have given up as unsuited to a commercial 
bank. 

The material in this case consists of excerpts from the credit file 
maintained by the bank. This file was typical of such material as col- 
lected by many banks on active loan accounts. It was divided into the 
following four sections for the Harbin account: correspondence; fi- 
nancial statements, as shown in Exhibits 1 and 2 (pp. 70-71 ) ; agency 
reports; and information. The latter section, which contained a sum- 
mary of discussions relating to the loan, may be summarized as follows: 

6/21/46 

Harbin [president of the Harbin Company] was introduced to Mr. Bancroft 
[president of the Fifth National Bank} by Charles Parkman [a friend of Mr. 
Bancroft's}, attorney for Harbin. 

The Harbin Company is engaged in selling bakery supplies and machinery. 
It was formed in February, 1943, by Associated Enterprises, Inc., for the purpose 
of carrying on a bakery supplies business purchased from City Supply Company. 
Associated Enterprises, Inc., is a holding company which controls a number of 
concerns in a variety of industries. City Supply Company is engaged in selling 
supplies and machinery to a number of industries throughout the eastern United 
States. Harbin was formerly with City Supply Company and decided to accept 
the position of manager of the new concern at the time of its organization. 

Associated Enterprises, Inc., has offered to sell the entire capital stock of the 
Harbin Company to Harbin for $250,000. He feels that he can get them to ac- 
cept $200,000. It will be necessary for him to borrow a substantial proportion of 
this amount. 

64 



Harbin Company 65 

After my first discussion with Harbin, I believe that we could make the loan 
only on the basis of the assignment of accounts receivable or inventory. Before 
proceeding further we should have Commager [a member of the bank's staff who 
specialized in accounts receivable loans} investigate these. 

JWC [John W. Channing, a vice-president] 

6/26/46 

The company maintains offices and a warehouse at 407 Prune Street. It is 
engaged in the distribution of supplies and machinery to commercial bakeries 
and institutions in the Philadelphia area. Terms of sale are n/30, but Mr. Harbin 
advised me that the turn of receivables in the trade averages between 50 and 60 
days. Machinery is sometimes sold on a deferred payment plan arranged with 
Supplier's Finance Company of New York City. I have checked with Mr. Ball, 
the Harbin Company's credit man, who has informed me that collections on 
deferred payment notes have been good. 

Twenty-five per cent of the receivables, as of June 1, 1946, were selected at 
random and aged. The results are as follows: 

Outstanding % 

May shipments 0-30 days $22,022.33 44 

April shipments 31-60 7,006.24 14 

March shipments 61-90 6,389.05 13 

Prior shipments 90+ 14,641.99 29 

Total $50,059.61 100 

Of the above total, $42,782.09 was comprised of accounts of $100 or more. 
Dun & Bradstreet's rating of these accounts is as follows: 

% 

1st grade $ 4,893.91 H 

2nd grade 4,571.16 11 

3rd grade 4,364.94 10 

4th grade 1,051.81 3 

Not rated 27,900-27 65 

Total $42,782.09 100 

Of the remaining 75% of the receivables, all accounts of over $100 were 
aged. The results are as follows: 

Outstanding % 

May shipments 0-30 days $ 75,469.14 48 

April shipments 31-60 21,459.41 14 

March shipments 61-90 17,105.67 11 

Prior shipments 90 + 43,482.76 28 

Total $157,516.98 100 

Invoices in the supply end of the business average about $50. Returns and 
allowances average about G.G% of shipments. 

I was favorably impressed with Mr. Ball, the credit man, who has been with 
the company since March 1. He has installed a new control system, which keeps 
him constantly informed on the status of the accounts. Improvement has been 
made in at least 75% of the accounts since the hiring of Mr. Ball. 



66 Case Problems in Finance 

Mr. Mack, the office manager, also impressed me favorably. He appears to 
have his records in excellent condition and is very co-operative. With Mr. Mack 
and Mr. Ball on the job I believe that the detail work connected with an ac- 
counts receivable loan could be handled without undue difficulty and confusion. 

Mr. Harbin took me through his warehouse. The supplies inventory appeared 
to be in good shape and fast moving. The machinery stock consists mostly of 
trade-ins. Mr. Harbin told me that there is a good profit on trade-ins. He is going 
to furnish a complete inventory of supplies and machinery in a day or two. 

Mr. Harbin remarked that he hoped that we could gQt together because he 
would prefer to do business with us rather than with Acme-Eastern Credit 
Corporation, which has offered to finance the purchase. 

WCC [Mr. Commager} 

7/2/46 
I have studied Commager 's report and the company's financial statements; 
the following unfavorable factors stand out: 

1. The poor class of receivables 

2. Consistent losses 

Against these we must consider the following favorable factors: 

1. The accounts are well diversified. If we allow ourselves sufficient margin 
they would be satisfactory collateral. 

2. The prospects for the bakery business look good for some time to come. 

If the company could be put on a profitable basis, which is possible if ex- 
traneous expenses are eliminated, we might consider the loan on this basis: 

1. 70% advance on receivables, limit of $145,000, and interest and service 
fees to total not less than 8% annually. 

2. A minimum of $25,000 should be invested as additional working capital. 

3. A starting minimum net working capital of $145,000, with provision in 
the loan agreement that net working capital should not fall below 
$125,000. 

4. No pledge of any other assets. 

Using May 31, 1946, balance sheet figures [given in Exhibit 2}, if the above 
were done the company would show the following approximate position after 
paying off its current bank loan: 



Current assets: 




Current liabilities: 




Cash 


. ..$ 8,500 






Accounts receivable . 


. . 199,000 


Banks 


■ $145,000 


Inventory 


. . . 197,000 


Other 


.... 114,000 




$404,500 




$259,000 



Harbin mentioned that he had $25,000 that he could invest. If he can get 
the price down to $200,000, he plans to give notes for $55,000 of the amount so 
as to be able to put the $25,000 into the business. 

JWC 



Harbin Company 67 

7/6/46 

Harbin was in today, and we discussed the following: 

1. Operating results for fiscal year ending August 31, 1945, after making 
adjustments for extraneous expenses. 

2. The maximum loan that we would be willing to consider, and the basis 
thereof. 

3. Method of purchasing the company in the event the loan is approved. 

Prospects for future operations are not bad, judging from the adjusted figures 
for the fiscal year 1945. [See Exhibit 1.} Unamortized nonrecurring expenses 
could be written off to surplus immediately without affecting working capital or 
future earnings. Consideration should be given to the unfavorable conditions pre- 
vailing during the period. The company was unable to get new machinery, which 
ordinarily comprises a substantial proportion of sales, and was unable to get its 
normal supply of certain types of yeast. 

Harbin states that he prepared his adjusted operating statements with a great 
deal of care and on a basis that he is confident he can attain. Reduction in selling 
expense will be achieved by transferring to sales two inside men who are not 
needed full time in their current jobs, thereby enabling the company to discharge 
two salesmen. Bad debt expense has been reduced because losses have averaged 
only $2,000 a year. Harbin justifies the decrease in cost of sales from 79% of 
sales to 77% on the ground that cost was only 76% in the previous period. 

I am impressed with Harbin's presentation and the thinking behind it, and 
I am confident that he can meet his estimates. 

We went over the adequacy of a $145,000 loan, if we can see our way clear 
to making it. I advised against a larger amount because it would tie up all the 
company's assets, thereby curtailing its sources of additional credit. Harbin agreed 
that a larger loan would be inadvisable. I suggested that he raise $50,000 cash, 
which he replied he could do. If the company can be had for $200,000 I sug- 
gested that he arrange that $55,000 be paid in the form of a five-year note. 

The following method of purchasing the company was worked out. The 
proceeds of the proposed loan would be used to purchase its stock for the com- 
pany's account. This stock would then be canceled. The remainder of the out- 
standing stock would be purchased by Harbin for his own account, payment 
being made by his personal note as described in the preceding paragraph. Harbin 
would thereby own 100% of the outstanding shares. 

The pro forma balance sheet giving effect to the proposed transaction is as 
follows: 

Current assets: 

Cash $ 33,000 

Net receivables (pledged) 199,000 

Inventory 197,000 

$429,000 



68 Case Problems in Finance 

Current liabilities: 

Bank debt $145,000 

Trade debt 114,000 

$259,000 
Net working capital 170,000 



JWC 



[Extract from summary of officers' loan committee meeting of July 9, 1946.} 
A revolving credit up to $145,000 based on pledged accounts receivable for 
the purpose of financing the purchase and operation of the business by Mr. 
Harbin was presented for discussion by Mr. Channing. 

A suggestion was made by Mr. Harlow [chairman of the officers' loan com- 
mittee and senior vice-president} that a thorough check be made into the moral 
standing and ability of Mr. Harbin and into the company's position in the trade 
and its prospects. Mr. Harlow stated that, in his opinion, too much reliance was 
being placed on Mr. Harbin's word without adequate outside corroboration. 

7/10/46 
Met on Tuesday with Harbin and his attorneys to discuss the possible basis 
for the loan, pointing out that it had not been approved. They seemed satisfied 
with: 75% advance on receivables, limit of $145,000, and interest rate of 6%, 
no less, plus a service charge of 2% to cover clerical costs in handling invoices. 
The question was raised of an additional loan if Harbin were unable to get 
the price down to $200,000. I replied that in that event I would discuss with our 
loan committee the possibility of a chattel mortgage on inventory for the addi- 
tional amount. 

JWC 

7/13/46 
Had lunch with Harbin. I told him that after reconsidering my previous 
statement about increasing the loan I had come to the conclusion that any 
amount in excess of $145,000 would be unsound from his point of view as well 
as from ours. He suggested that the $50,000 he planned to put in the business 
could be applied, if necessary, to the purchase. I said that we would cross that 
bridge when we came to it. Meanwhile, I recommended that he continue his 
negotiations with Associated Enterprises. 

JWC 

7/18/46 
I have made inquiries through friends about Harbin and the company. His 
former employers, the City Supply Company, have a high regard for his honesty 
and business ability. Harbin is respected by his competitors and is well and 
favorably known in the local bakery trade. There were a number of favorable 
comments on his ability and experience as a salesman. He will have good assist- 
ants to handle routine work. Mack has the office and books in good shape, and 
we are counting on him and Ball to handle the figure work. 

JWC 



Harbin Company 69 

7/26/46 

Harbin was in today and was in high spirits. With the aid of friends he has 
been able to raise a total of $75,000. He also stated that Associated Enterprises 
has agreed to accept as part payment a $55,000 five-year note secured by all the 
capital stock left outstanding after cancellation of stock purchased by the com- 
pany with the proceeds of the loan. He expects the negotiations to be completed 
within the next two weeks but has not been successful yet in having Associated 
agree to the figure of $200,000. It looks as if they will not be agreeable to the 
new price. 

If the deal goes through at $250,000, the money will be raised as follows: 

Loan from us to company, secured by accounts receivable $145,000 

From Harbin and friends 75,000 

5-year note given by Harbin to Associated Enterprises 55,000 

$275,000 

To Associated Enterprises 250,000 

Available funds to be invested in Harbin Company $ 25,000 

As I understand the plans, the transaction would go this way: 

a) We loan the Harbin Company $145,000 against its accounts receivable. 

b) The company uses the $145,000 to buy l45/250ths of its stock from As- 
sociated Enterprises. This stock would be canceled. 

c) Mr. Harbin buys the remaining stock from Associated Enterprises. He 
pays $50,000 in cash and gives his personal note for $55,000 to Asso- 
ciated Enterprises. He also posts his stock holdings as collateral for the 
$55,000 note. 

d) Mr. Harbin puts $25,000 in the business in return for common stock to 
be issued by the company to him. 

Following these transactions the current asset and liability picture ( working 
from May 31, 1946 figures) would be changed to following: 

Current assets: 

Cash $ 9,000 ($18,000 on %i 4- $25,000 new money 

less $34,000 used to pay old loan) 

Accounts receivable 199,000 (Pledged to us) 

Inventory 197,000 (Same as %i) 

$405,000 

Current liabilities: 

Bank debt $145,000 (Old loan of $34,000 paid off) 

Accounts payable and 

accrued items 114,000 (Same as %i) 

$259,000 



Net working capital $146,000 



JWC 



70 Case Problems in Finance 

Exhibit 1 

HARBIN COMPANY 

Operating Statements 

Actual Actual Adjusted Actual 

6 Months to 12 Months to 12 Months to 9 Months to 

Aug. 51, 1944 Aug. 51, 1945 Aug. 51, 1945 May 51, 1946 

Sales $384,237 $956,259 $956,259 $695,286 

Less: Cost of sales. . 291,789 754,992 736,695 552,762 

Gross profit $ 92,448 

Add: Commissions. . 6,741 
Total $ 99,189 



Less: Operating ex- 
penses : 
Selling expense. . .$ 34,668 

Advertising 3,852 

Collection ex- 
pense 96 

Provision for bad 

debts 7,705 

Royalties 1,348 

Handling expense. 11,171 
Machine shop 

expense 963 

Administrative 

expense 9,437 

Office expense ... 16,371 
Balance $ 13,578 

Add: Discounts re- 
ceived 3,178 



Total $ 16,756 

Less: Other charges: 

Interest paid $ 763 

Discounts allowed. 2,793 
Profit before amortization of 

nonrecurring expenses. . 13,200 

Less: Amortization . . 6,081 

Net profit or loss $ 7,119 

Dividend paid 



$201,267 
578 


$219,564 
578 


$142,524 
362 


$201,845 


$220,142 


$142,886 


$ 74,151 
5,297 


$ 66,929 
4,334 


$ 


51,424 
1,830 


556 


556 




418 


10,015 

1,926 

28,890 


4,815 

1,926 

28,890 




7,237 

1,422 

24,687 


963 


963 




1,787 


24,653 
40,831 


24,653 
40,831 




17,351 
28,120 


$ 14,563 


$ 46,245 


$ 


8,610 


10,305 


10,305 




9,004 


$ 24,868 


$ 56,550 


1 


17,614 


$ 1,926 
8,667 


$ 1,926 
8,667 


$ 


963 
7,896 


$ 14,275 
28,332 


$ 45,957 
None 


$ 


8,755 
15,200 


$ 14,057'' 


$ 45,957 


$_ 


6,445^^ 






$ 


6,428 



Harbin Company 71 

Exhibit 2 

HARBIN COMPANY 

Balance Sheets 

(Dollar figures in thousands) 

ASSETS 

Aug. 31 Aug. 31 May 31 

1944 1945 1946 
Current assets'. 

Cash $ 38 $ 67 $ 18 

Accounts receivable (net) 126 149 199 

Inventories (net) 123 177 197 

Total current assets $289 $393 $414 

Other assets'. 

Machinery and fixtures (net) 11 13 13 

Other notes and accounts 

receivable 1 

Prepaid items 7 

_ Organization expense* 44 

Purchase of officer's contract* 

Total assets $352 

LIABILITIES AND CAPITAL 

Current liabilities: 

Bank loans 

Accounts payable $ 38 

Accrued items 11 

Reserve for federal taxes 3 

Deposits on containers 8 

Due to affiliated company 49 

Total current liabilities $ 1 09 

Capital: 

Common stock — $10 par $241 

Earned surplus or deficit 2 

Capital surplus 

Total capital $243 

Total liabilities and capital $352 

d Deficit. 

* Nonrecurring expenses being amortized (Exhibit 1). 



5 


8 


10 


6 


15 


8 


19 


11 


$455 


$460 



$ 48 
54 
14 


$ 34 

104 

10 


13 

1 
$130 


$148 


$289 
XT' 
48 


$289 
48 


$325 

$455 


$312 
$460 



VVVV\VVVVVVVVVVVVVVVVVVVVVtVVVV\VVVVV\VVVVVVVVVVM^VVVVVVV^ 



Santos Coffee Company 



VWVVVVVVVVVVVVV\VVV\VVVWVVVVVM^VVVVVVVVVVVVVVVVVVWVVVVA\VWV\^^ 



Early in July, 1947, Mr. John Richards, a credit officer of the Free 
State Bank of Baltimore, Maryland, was considering what action the 
bank should take regarding a large unsecured loan to the Santos Coffee 
Company. In recent months a series of undesirable developments in con- 
nection with the loan had convinced Mr. Richards that the present situa- 
tion was highly unsatisfactory from the bank's viewpoint. It seemed to 
him that unless the loan could be covered by adequate security the bank 
would have to insist on payment of the loan even though such action 
might result in liquidation of the company. Since the company owned 
little real property, the only possible collateral was the company's ac- 
counts receivable and inventory. 

The Santos Coffee Company had been founded in 1929 by four 
salesmen who had worked previously for a large coffee roasting firm in 
Baltimore. The new company operated as an importer, roaster, and 
wholesaler of coffee. 

The company customarily ordered its principal raw material, green 
coffee in bean form, from Brazilian exporters. Shipment was made from 
Santos, the principal coffee exporting port of Brazil. The method by 
which payment for the coffee was accomplished is outlined as follows: 
When a shipment was loaded aboard ship, the Brazilian exporter drew 
a draft on the Santos Coffee Company for the agreed dollar value of the 
shipment. The draft usually called for payment "on sight," that is, 
within three days after presentation of the draft to the company. With 
"shipping papers"^ attached, the draft was then deposited for collection 
by the Brazilian exporter at its bank. This bank forwarded the draft and 
attached papers to its correspondent bank in the United States, which in 
turn sent it on to the Free State Bank, which paid the draft as instructed 

''■ Consisting typically of invoices, ocean bill of lading, marine insurance certificates, 
and consular certificates. 

17. 



Santos Coffee Company 73 

by the Santos Coffee Company. Upon payment of the draft, the Free 
State Bank turned over the shipping papers to Santos, so that it could 
claim the coffee upon arrival in Baltimore. 

Soon after the Santos Coffee Company moved its account to the Free 
State Bank in 1934, it arranged to borrow up to $30,000 from the bank 
to meet drafts for shipments of coffee. As the bank advanced the funds 
to pay for a particular shipment, it prepared a demand note for the 
amount of the advance. The note also gave the bank legal title to the 
coffee until the note was paid. Although the bank held title to the coffee, 
it released the coffee to the company for storage under a legal arrange- 
ment known as a "trust receipt." It was the customary practice of the 
company to pay the note secured by a particular shipment of coffee when 
it removed that coffee from storage for processing. Each trust receipt 
identified the particular shipment involved by reference to distinctive 
marks on the coffee bags in that shipment. 

During the 10 years from 1934 to 1944, the company's sales grad- 
ually increased and the amounts of money advanced for the company by 
the bank against coffee also increased. The bank also made additional 
unsecured advances to the company on a demand basis from time to time. 
By 1944, total advances to the company amounted at times to as much 
as $40,000. Since the company continued to show modest profits and 
sales increased somewhat, and since the company had only small debts 
owing to other creditors, the bank had taken no steps to see that the 
company was fully carrying out its obligations under the trust receipt 
arrangements. For example, the bank made no inspections of the inven- 
tory outstanding under the various trust receipts to make sure that it 
could be readily identified and that the company had reported promptly 
all withdrawals from storage. In the absence of these precautions, the 
bank regarded the advances against coffee under the trust receipts as, 
in fact, unsecured loans. 

In 1944, Mr. John Stone, who had served as president of the com- 
pany since its inception, died. Mr. Stone was succeeded by Mr. R. H. 
Sager, formerly sales manager for the company. At the time the bank 
was somewhat concerned about the future management of the company, 
since all of the remaining officials were experienced primarily in the sales 
aspects of the business. Operations continued satisfactorily, however, and 
a profit of more than $5,000 was recorded in 1945. Late in 1945 the 
bank learned that Mr. Pierre LeBlanc, one of the salesmen, had pur- 
chased Mr. Stone's shares of common stock from his estate. This gave 



74 Case Problems in Finance 

Mr. LeBlanc 385 shares out of the total of 890 shares outstanding. Con- 
sequently, Mr. LeBlanc assumed direction of the company with the title 
of vice-president and general manager. 

Under Mr. LeBlanc's leadership the company undertook a program 
of aggressive sales promotion. Sales were made principally to independ- 
ent retailers and to restaurants and hotels. In 1946 the company had 
more than 3,400 accounts in Maryland, the District of Columbia, Vir- 
ginia, and southern Delaware. Late in 1946, subsequent to the removal 
of OPA price restrictions on coffee, there was a sharp increase in both 
the price of green coffee and in the company's selling prices. However, 
the increase in prices accounted for only a portion of an increase in net 
sales from $432,000 in 1945 to $781,000 in 1946. Profits increased 
from $5,472 to $9,537. 

During the latter part of 1946 the bank agreed to increase the 
amount of credit granted to the company in view of the increased work- 
ing capital requirements as a result of higher sales and higher prices. A 
tentative maximum line of credit of $80,000 was established. 

Early in January, 1947, Mr. LeBlanc requested that the line of credit 
be increased further. He explained that the company was currently 
spending large amounts on advertising and expected a further increase in 
sales. Mr. Richards had agreed to the increase in the line of credit in late 
1946 to $80,000 with considerable reluctance since he felt that the addi- 
tional sales should more properly be financed by increased capital invest- 
ment by the owners. Therefore, he declined to advance the line beyond 
$80,000 but promised to lay the matter before the officers' loan com- 
mittee of the bank. 

Shortly thereafter, in late January, 1947, Mr. Richards had a tele- 
phone call from an officer of the Chesapeake Trust Company, who in- 
formed him that the Santos Coffee Company had opened a borrowing 
account with the Chesapeake Trust Company in the fall of 1946 and 
was currently borrowing some $35,000 from that bank. The other 
banker expressed some dissatisfaction with his new account particularly 
when Mr. Richards told him that this was the first news the Free State 
Bank had that Santos was borrowing from another bank. Shortly there- 
after the Free State Bank received a copy of the audited annual report as 
of December 31, 1946, which confirmed the fact of outside borrowing. 
The balance sheet of the company on December 31 showed ''notes pay- 
able to banks" of $105,000. Since $70,000 was outstanding from the 
Free State Bank, $35,000 was apparently owing the Chesapeake Trust 



Santos Coffee Company 75 

on that date. Other payables also showed a substantial increase over the 
1945 figures. Accordingly, Mr. Richards asked Mr. LeBlanc to come in 
and see him. In an ensuing discussion, he expressed dissatisfaction with 
Mr. LeBlanc's action in borrowing from another bank without inform- 
ing the Free State Bank. He further stated that the Free State line of 
credit of $80,000 was based on the assumption that the company would 
not borrow from any other bank. He stated flatly that if Mr. LeBlanc did 
not accept this arrangement he would have to pay off all the Free State 
loans and seek other banking accommodations. Mr. LeBlanc agreed to 
pay off the loans from the Chesapeake Trust Company and to reduce the 
scale of his operations so that $80,000 would be sufficient bank credit 
for the company's needs. 

Despite the previous understanding, Mr. LeBlanc soon requested a 
temporary increase in the loans above $80,000 on the ground that he 
needed at least 2,200 bags of coffee in stock to meet his sales require- 
ments and that the financing of this much inventory together with the 
other needs of the business would require an increase in the loan above 
$80,000. Mr. Richards replied that $80,000 was the bank's top limit 
and suggested that the company build up its capital through earnings 
and through the sale of preferred stock. Mr. LeBlanc agreed to under- 
take to find additional capital. 

Early in May a representative of the bank visited the company and 
made a brief inspection of the inventory. A classification of the inventory 
of the company on April 30 was obtained. This was as follows: 

Thousands of 
Dollars 

Green coffee 37.6 

Roasted coffee 12.6 

Tea 15.9 

Groceries and miscellaneous supplies 6.8 

Manufacturing supplies 38.6 

111.5 

Upon inquiry it was learned that the manufacturing supplies consisted 
largely of glass containers, which had been purchased in quantity during 
a shortage period. Very recently adequate supplies of tin containers had 
become available. Since tin containers were regarded as much more satis- 
factory, the company had shifted back to use of tin. There were more 
than five carloads of surplus glass containers. When pressed for an ap- 
praisal of the value of these containers, Mr. LeBlanc conceded that a 
loss of as much as $14,000 might be expected when they were sold. 



76 Case Problems in Finance 

In addition it was learned that recent operations of the company had 
not proved profitable although sales were large. In another conversation 
with Mr. LeBlanc, based on this information, Mr. Richards urged him to 
reduce the currently large expenditures for advertising and to try to re- 
duce the loan to $55,000. Mr. LeBlanc agreed to do so. He also agreed to 
make available to Mr. Richards the financial statements of the company 
as of June 30 as soon as they were available. 

Copies of the balance sheet and profit and loss statement for the first 
six months of the year were received by the bank on July 10. (See Ex- 
hibits 1 and 2.) Mr. Richards found the statements highly disturbing. 
Net working capital amounted to only $39,000 compared with total 
debt of $140,000. In addition, although the first half of 1947 had been 
a period of general prosperity and good corporate earnings, the Santos 
Coifee Company showed a loss of $34,000 for the period. At this stage, 
Mr. Richards was convinced that drastic action was necessary if the 
bank's interests were to be fully protected and possible loss prevented. 
While he was determining what action to recommend to the officers' loan 
committee, he received a call from Mr. Sager, one of the original found- 
ers of the firm and the manager during the year intervening between 
the death of Mr. Stone in 1944 and Mr. LeBlanc's assumption of the job 
late in 1945. Mr. Sager informed Mr. Richards that the stockholders had 
determined that a change in management was desirable. Mr. LeBlanc 
had agreed to resign as general manager and to resume his old duties 
as salesman. Mr. Sager was assuming the job of treasurer and with other 
stockholders would assume active management of the company. He 
agreed that the affairs of the company were in poor shape but expressed 
the strong hope that the bank would give the new management a chance 
to pull the company out of its current difficulty. He explained that the 
large expenditures for advertising had been terminated, that pressure 
was being put on overdue accounts receivable, that the recent practice of 
cutting profit margins to get additional sales would be stopped, that 
salaries were being reduced, and that every step to conserve funds was 
being taken. He asked Mr. Richards to tell him within a few days what 
the bank would do in regard to meeting the credit needs of the company. 

Mr. Richards was impressed with the earnestness of Mr. Sager's ap- 
peal and with his apparent grasp of the management mistakes which 
appeared to be the cause of the company's difficulties. In view of all the 
facts, however, Mr. Richards decided that the Santos Coffee Company 
account should no longer be carried on an unsecured basis. In general. 



Santos Coffee Company 77 

the Free State Bank had followed a policy of trying to work out of dif- 
ficult situations, where there seemed a reasonable opportunity to do so, 
rather than forcing liquidation of borrowing customers. 

Mr. Richards first centered his attention on the possibilities of secur- 
ing a pledge of accounts receivable. In order to get a better idea of the 
company's accounts receivable, a representative of the bank was asked to 
undertake an aging of the accounts outstanding on June 30. He reported 
that the company had several thousand accounts, so that the average 
balance and the individual invoices were small. Of the $75,000 of re- 
ceivables outstanding on June 30, $52,000 were current or no more 
than 30 days overdue. Of the remaining $23,000, $15,000 of the ac- 
counts were over 90 days overdue. Returns and allowances were very 
small. 

Mr. Richards next focused his attention on the value of the com- 
pany's inventory as collateral. Upon investigation he found that the 
green coffee used by the company consisted primarily of common grades 
of Brazilian coffee for which there was a continuous and rather wide 
market in Baltimore and in the neighboring cities. At any one time, part 
of the coffee was in ocean transit to the company. Green coffee actually 
on hand, preparatory to being roasted, was stored in vacant space in the 
building which the company rented. The company felt that it was es- 
sential to carry a substantial supply of green coffee, either on hand or 
en route to it, in order to insure no interruption in its supplies. Such a 
supply would at current prices amount to between $35,000 and $55,000 
in total value. As a part of the retrenchment program, the new manage- 
ment planned to concentrate on the sale of coffee, reducing the June 30, 
1947 inventory in tea and other lines. 

Upon investigation, Mr. Richards verified his opinion that coffee in 
the green state could be held for many months without substantial de- 
terioration, provided clean, dry storage was available and no other com- 
modities of strong aroma were stored near by. He also investigated recent 
movements in green coffee prices. The results of the investigation of 
prices are shown in Exhibit 3. Mr. Richards learned that the government 
of Brazil, the country which accounted for more than 70% of world pro- 
duction of coffee, had for a number of years made strenuous efforts to 
maintain the price of coffee at what it considered reasonable levels. 
These efforts largely took the form of restriction on coffee exports so 
that they did not exceed world demand. When necessary, substantial 
stocks had been destroyed in Brazil in order to reduce supply in the world 



78 Case Problems in Finance 

market. Consequently, some observers currently felt that the Brazilian 
government would take energetic steps to try to prevent any substantial 
decline from the current high prices. 

Mr. Richards also investigated the possibility of getting a secured 
position in regard to the green coffee which would be unquestionably 
valid against general creditors in the event of bankruptcy of the firm. 
The trust receipt method of taking security on the coffee left some doubts 
on this score. He learned that there was an independent public ware- 
house across the street from the building in which the company operated, 
which had surplus space available at reasonable charges. He then con- 
ceived the following plan for loaning against the inventory: When 
drafts covering the new shipments of coffee were received, the bank 
would advance money to meet the drafts. Immediately, trust receipts 
describing the bags in the shipment would be prepared and executed by 
the company. Thus, the bank would have a secured position on the coffee 
while it was in transit. Marine insurance would be carried and made out 
so as to recognize the bank's security interest in the coffee in transit. 
When the coffee arrived in Baltimore, it would be moved immediately to 
the public warehouse. The warehouser would issue a warehouse receipt 
naming the bank as owner of the coffee. The warehouse receipt would 
be held by the bank, which would then return the trust receipt to the 
company. When the company needed the coffee for roasting, it would 
pay the bank the full amount of the loan advanced against the coffee. 
Thereupon, the bank would direct the warehouse company to release the 
coffee to Santos. 

Such a procedure, Mr. Richards felt, would insure that the bank 
could properly identify the security back of the inventory loan and estab- 
lish beyond challenge the bank's ownership of the coffee. The ware- 
houseman was bonded to perform his duties properly, and the coffee 
while in the warehouse would be covered by fire and other insurance. 
The proposed procedure would involve some expense and trouble for 
the company since it now stored its green coffee in otherwise useless 
space in its rented building. The company would be required to pay the 
storage charges of the bonded warehouse and, in addition, would incur 
expense for trucking and handling charges in and out of the warehouse. 

After careful study, Mr. Richards concluded that the bank could 
probably escape with little or no loss if it demanded payment of the loans 
now and liquidation of the company resulted. Therefore, the major alter- 
natives now open to the bank seemed to boil down to the following: 



Santos Coffee Company 79 

1. Demand payment of the loans. 

2. Continue to loan to the company reasonable amounts on the basis of a 
pledge of accounts receivable. 

3. Continue to loan to the company by advancing reasonable amounts of 
funds against drafts for shipments of coffee only if the coffee were moved 
into the public warehouse immediately upon arrival and warehouse re- 
ceipts pledged as security for the loan. 

4. A combination of 2 and 3. 

Exhibit 1 

SANTOS COFFEE COMPANY 

Balance Sheets 

(Dollar figures in thousands) 

Dec. 31 Dec. 31 ]une 30 Dec. 31 June 30 

1944 1945 1946 1946 1947 

Cash $21 $12 $14 $12 $16 

Accounts receivable, net 37 47 62 87 75 

Inventory 46 65 97 129 88 

Total current assets $104 $124 $173 $228 $179 

Machinery and fixtures, net 7 13 18 17 18 

Other notes and accounts receivable ... 2 2 2 2 2 

Goodwill 28 28 28 28 28 

Prepaid expenses 1 1 2 2 3 

Total assets $142 $168 $223 $277 $230 

Notes payable — trade ... ... ... $ 10 

Notes payable— banks $21 $28 $37 $105 74 

Accounts payable — trade 2 11 48 26 46 

Accrued expense 1 5 3 13 4 

Reserve for taxes 4 4 7 4 6 

Total current liabilities $28 $ 48 $ 95 $148 $140 

Common stock ($100 par) 89 89 89 89 89 

Surplus 25 31 39 40 1 

Total liabilities $142 $168 $223 $277 $230 

Exhibit 2 

SANTOS COFFEE COMPANY 

Income Statements 

(Dollar figures in thousands) 

Year Year 6 Months Year 6 Months 

1944 1945 1946 1946 1947 

Net sales $310.7 $431.8 $323.7 $780.7 $361.7 

Gross profit 55.5 84.2 75.1 180.9 67.2 

Administrative and selling expense ... 51.7 78.4 60.3 161.9 97.2 

Operating profit 3.8 5.8 14.8 19.0 30.0* 

Other income (purchase discounts) . . 1.2 2.8 0.9 1.4 0.2 

Charges against income 4.8 3.1 7.3 10.9 4.2 

Net income 0.2 5.5 8.4 9-5 34.0* 

Common dividends 0.9 ... ... ... 4.0 

* Loss. 



80 Case Problems in Finance 





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Garnet Abrasive Company, Inc. 



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In October, 1945, A. T. Sohier, treasurer of the Garnet Abrasive 
Company, Inc., of Philadelphia, Pennsylvania, was convinced that his 
company would need substantial additional funds for a period of several 
years; and he was considering the wisdom of recommending to the board 
of directors that the proposal of two local banks to arrange a term loan 
be accepted. 

The Garnet Abrasive Company, Inc., which was established in 1928 
for the manufacture of sandpaper abrasives, had made rapid progress in 
most years since its inception. The company had been started by Mr. 
Sohier together with N. C. Carroll, president, and D. M. Oliver, a former 
vice-president, who had retired in 1944. The organization of the new 
enterprise indirectly was attributable to the circumstance that when an- 
other abrasive manufacturing company, of which Mr. Carroll was then 
sales manager, was purchased by one of the largest manufacturers in the 
industry, Mr. Carroll decided not to continue with the company. His 
decision to resign was influenced by the fact that, as the result of con- 
siderable investigation, he had become convinced that there was need 
for a new unit in the industry and that a new company could operate 
profitably on a modest scale. He discussed his ideas with Mr. Sohier, who 
was employed at the time as auditor in a textile manufacturing company, 
and obtained his co-operation in a plan for organizing such a company. 
The two men then succeeded in inducing Mr. Oliver to join them in the 
undertaking. 

None of the men had a large fortune, but together they were able to 
invest a total of $65,000 in the business. They purchased a small plant 
in an industrial section of Philadelphia and started production of sand- 
paper. Mr. Carroll devoted his attention largely to sales promotion, while 
Mr. Sohier concentrated on financial and accounting problems and Mr. 
Oliver was placed in charge of planning production. 

81 



82 Case Problems in Finance 

For two years the new company's operations were unprofitable, with 
losses totaling $40,000. The company became unable to pay its trade 
debt promptly, with the result that the largest trade creditors threatened 
to force the company into bankruptcy. A conference of three of the larg- 
est of these creditors was called in an effort to postpone drastic action. 
One supplier agreed not to force the company into liquidation, and the 
other two major creditors concurred in this decision. This agreement 
may be considered to be a turning point in the company's affairs. 

As one method of conserving funds for necessary operation, the 
management instituted all possible economies to the point, for example, 
of reducing unnecessary lighting in the plant to cut down bills for elec- 
tricity and of substituting glasses at the water faucets to eliminate the 
cost of paper cups. Even with the co-operation of the trade creditors and 
the strictest economies, there were times when no cash was available to 
pay for C.O.D. deliveries of raw materials. On some occasions the em- 
ployees advanced small amounts in order to permit delivery of materials. 

In 1930, shortly after this low point in the company's affairs, two 
concerns which sold to the building industry large amounts of abrasive 
products for use with machines they manufactured, commenced buying 
a large part of their abrasive requirements from the company. With this 
increased volume of sales, operations became profitable for the first time. 
Rapid acceptance of the company's product by other customers followed 
and soon resulted in a volume of production which taxed the capacity of 
the manufacturing plant. Unlike many concerns, the company's volume 
of sales and profits grew in each of the depression years. 

In 1931 it became necessary for the company to move to a larger 
plant. The property of a textile manufacturing company which had been 
liquidated during the depression was for sale and was suited to the com- 
pany's needs. The plant was served by good rail transportation and a 
satisfactory supply of labor was available in the neighborhood of the 
plant. The plant comprised two buildings, each four stories in height. 
One building was large enough to house all the company's activities at 
the outset, and the other building was available to take care of any sub- 
sequent expansion in operations. The price asked for the property was 
$55,000. By paying $6,500 in cash and assuming responsibility for an 
existing mortgage of $48,500, the company acquired the property and 
moved into the brick building. 

Late in 1936, the company sold $250,000, par value, of 7% pre- 
ferred stock through an investment banking house to several hundred 



Garnet Abrasive Company, Inc. 83 

investors in the environs of Philadelphia. Dividends on this preferred 
stock had always been paid. The outstanding common stock was in- 
creased from time to time by stock dividends but remained in the hands 
of Messrs. Sohier, Carroll, and Oliver. No common dividends had been 
paid since 1942. By 1940 the company had become fourth in size in the 
industry and was using both buildings. 

The particular type of abrasive product made by the Garnet Abrasive 
Company, Inc., consisted of a backing material, usually paper or cloth, 
that was coated with abrasive grains by the application of specially pre- 
pared adhesives. The finished products varied according to the type of 
backing, the type and size of the abrasive grains used, and the size and 
shape into which the coated materials ultimately were cut. Inventory 
cards showed that there were 20,000 different specifications for the fin- 
ished products. 

One widely used group of products was common sandpaper made by 
the application of flint grains to a stiff paper backing; the market for this 
group of products was highly competitive. Other types of abrasive ma- 
terials used included garnet grains which, like flint, were a mineral 
product but had sharper cutting edges and more durability than the flint 
grains, and synthetic abrasive grains, such as aluminum oxide and silicon 
carbide. 

The development of the garnet type abrasive paper was, in the opin- 
ion of the management, a major factor in its success during the depres- 
sion years. The cost of producing this abrasive was considerably higher 
than the ordinary flint paper, but the market was not so competitive and 
sales produced a better average gross margin of profit than the more 
competitive flint line. The abrasives made from the synthetic grains also 
produced a larger gross margin of profit than the flint products. 

It was difficult to determine all the uses for the products because of 
the diversity of industries which were the ultimate consumers. The build- 
ing industry, the woodworking industry, and the metalworking industry 
were, by and large, the most important markets. Another major cus- 
tomer was the shoe industry, and a substantial volume was sold to felt 
hat manufacturers. 

Many of the industrial users required that the product be made into 
special grades and shapes. Although a large portion of the flint product 
was sold as common 9X11 inch sheets of sandpaper to wholesale and 
retail establishments throughout the country for use by carpenters and 
others, it was also prepared for industrial users according to their specifi- 



84 Case Problems in Finance 

cations. The garnet and synthetic products were generally sold to in- 
dustrial users. Other specifications had been worked out for the abrasive 
materials sold for machines used in the woodworking and metalworking 
industries. 

There was a constant danger of overstocking the special shapes and 
sizes. To guard against obsolete inventories the management adopted the 
policy of producing the unusual grades on order as much as possible, 
although it was necessary to maintain a small inventory of some grades 
in order to provide quick service. 

The company's volume of sales had increased steadily from 1933 to 
1941, but gross profit on sales and net profits had not tended to expand 
in proportion to the increase in sales. See tabulation of net sales, gross 
profit on sales, net profits, and earned surplus shown in Exhibit 1. Mr. 
Sohier attributed the flattening out of sales as well as gross profits during 
the war years to a number of factors. He believed that sales had failed to 
increase mainly because of restriaions on building and furniture manu- 
facturing. Profits were reduced by the combined effect of cost increases 
and price ceilings. During the war, munitions establishments in the area 
had paid considerably higher wages than had the company. As a result 
many employees left and those who remained tended to become dissatis- 
fied and to be less efficient. The company had found it necessary to in- 
crease its hourly wages in an attempt to offset these factors. Labor cost 

Exhibit 1 

GARNET ABRASIVE COMPANY, INC. 

Income Data 

(Dollar figures in thousands) 

Gross Profit Net Per Cent Earned 

Net on Profit Gross Profit Surplus 

Sales Sales after Taxes to Sales End of Period 

1933 $ 516 $156 $ 40 30.8 $ 53 

1934 573 165 57 28.9 110 

1935 782 249 90 31.9 78 

1936 1,039 370 142 35.5 146 

1937 1,291 378 100 29.2 165 

1938 1,068 323 67 30.3 169 

1939 1,322 412 118 31.2 239 

1940 1,428 407 94 28.5 291 

1941 2,104 604 146 28.7 386 

1942 1,906 491 85 25.7 443 

1943 1,980 476 76 24.0 505 

1944 1,964 457 59 23.3 540 

1945 to Sept. 29. 1,423 293 10 20.6 537 



Garnet Abrasive Company, Inc. 85 

for a unit of output had therefore increased. Likewise, prices for the raw 
materials had shown a tendency gradually to rise. With price ceilings on 
the finished product rigidly enforced, the company had been unable to 
maintain its prewar margin of profit. 

With the prospective lifting of price ceilings, company ofiicials an- 
ticipated higher prices for the company's products and a return to prewar 
profit margins. While the company's costs had increased, it was believed 
that the costs of competitors had increased at least proportionately. Con- 
sequently, the company's position within the industry seemed favorable. 

In considering the company's financial needs in the immediate post- 
war period, the management was faced with many uncertainties. A 
major market would be the building industry. The executives were aware 
that a large deferred demand for building existed but were not confident 
that conditions were right to permit rapid expansion in the industry. The 
great increase in building costs might defer the beginning of a building 
boom. A similar situation existed in the furniture manufacturing indus- 
try, which was a large consumer of abrasives. Many furniture manufac- 
turing companies had operated at low volume throughout the war years, 
and it was expected that demand for new furniture would be strong. 
This industry, however, would be influenced by the rate of construction 
of new homes. Its cost structure had also risen substantially during the 
war period. In 1945, numerous strikes were threatening in the metal- 
working industry, so that a considerable period of time might elapse be- 
fore many of the large units, such as the automobile manufacturing 
companies, would get into full production. 

In spite of the uncertainties, the management was convinced that a 
substantial sum of money should be spent in order to insure the com- 
pany's position in the industry. The expansion of the company had thus 
far been financed principally from two sources — retained earnings and 
short-term bank borrowings. The company's banks had shown confi- 
dence in the management and had lent as much as $250,000 at 2% 
interest. The company had steadily made use of its lines of credit with 
the banks; notes payable usually were outstanding in amounts varying 
from $150,000 to $250,000. The treasurer believed that a type of capi- 
tal more permanent than short-term bank loans would be desirable when 
the business developed as he hoped it would. 

In addition to these financing needs, Mr. Sohier foresaw that in the 
neighborhood of $200,000 should be spent within a year to improve the 
plant and increase productive efliciency. Little equipment had been re- 



86 



Case Problems in Finance 



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88 Case Problems in Finance 

placed during the war, and the company's machinery was subject to 
unusual deterioration because of the nature of the manufacturing proc- 
ess. The abrasive grains penetrated all the moving parts of the machin- 
ery, with the result that the machines wore out rapidly. Depreciation 
charges and expenses for repairs were so high that these items had at 
times been questioned by the Bureau of Internal Revenue, although the 
amounts as stated had always been accepted after investigation. ( See Ex- 
hibit 2 [pp. 86-87} ) . Most of the machines were designed by the plant 
engineer and built to order by machine shops in the vicinity. 

The steady rise in labor costs which had taken place was, in the 
opinion of the management, a further reason to install new equipment 
that would be more efficient and automatic. 

In addition to expenditures for new machinery, the company was 
faced with an outlay of about $55,000 for a new ventilating system. 
The State Board of Health was insisting that methods be devised to pro- 
tect the workers against the abrasive dust. On the basis of experience the 
management was convinced that the dust produced in the manufacture 
of abrasives was not toxic or otherwise injurious to the employees' 
health. It appeared necessary, nevertheless, to comply with the require- 
ments of the health board. 

Thus, Mr. Sohier concluded that the need for funds amounted to at 
least $505,000, broken down as follows: 

Replacement of short-term borrowings to meet working capital needs .$250,000 

New machinery 200,000 

New ventilating system 55,000 

$505,000 

This estimate did not allow for additional working capital that might be 
needed if sales increased substantially. 

The company did not prepare a detailed budget of cash receipts and 
expenditures, and the estimates of financial needs which Mr. Sohier used 
were therefore based principally upon his own knowledge of the com- 
pany's requirements together with information gained from conversa- 
tions with other executives of the company. In spite of some uncertainties 
regarding the amounts needed and the time the funds would be em- 
ployed, Mr. Sohier was convinced that conditions were advantageous 
for obtaining longer term funds. He proceeded to discuss the problem 
with officers in his company's banks and to work out with them tentative 
plans for the financing. 

The company's two principal banks expressed willingness to make 



Garnet Abrasive Company, Inc. 89 

term loans to the company in the amount of $550,000 payable in in- 
stallments from 1946 to 1950. During preliminary conversations with 
the bankers in July, 1945, the following provisions for a term loan 
agreement had been developed: 

1. The principal amount would be $550,000. 

2. The loan would be repaid in the following installments: 

On or before January 1, 1946 $ 30,000 

On or before January 1, 1947 75,000 

On or before January 1, 1948 75,000 

On or before January 1, 1949 1 10,000 

On or before January 1, 1950 1 10,000 

On or before Oaober 1, 1950 150,000 

3. The loan would be evidenced by two negotiable promissory notes, one in 
the amount of $400,000 to the larger of the two banks and one for $150,000 to 
the smaller bank. 

4. Payments would be made pro rata on the two notes. The company would 
have the option of paying semiannual instead of annual installments. All or any 
part of the loan might be paid in advance of the foregoing schedule without 
penalty to the company unless the company borrowed from others for the purpose 
of paying the loans, when the bank would require a premium of 1% of the 
principal amount so paid. 

5. Interest at the annual rate of 3% would be paid quarterly at the end of 
each quarter. 

6. The company would agree that, during the life of the loans, net working 
capital would not be reduced below $750,000, except that after each payment of 
$75,000 the requirements for minimum net working capital would be reduced 
by $35,000 and upon payment of each $110,000 the requirement would be re- 
duced by $45,000. Net working capital would be defined as the excess of current 
assets over current liabilities and would be determined in accordance with gen- 
erally accepted accounting practices. Current liabilities would include all obliga- 
tions due within 12 months. 

7. The company would agree that its total debt would at no time exceed 
$850,000; in the calculation of these liabilities all accrued taxes were to be in- 
cluded. 

8. The company would agree to pay no dividends and would retire no 
shares of capital stock except that four quarterly dividends might be paid on the 
7% cumulative preferred stock annually. 

9. The company would agree not to sell or pledge any assets in excess of 
$25,000 without written permission from the banks. The company would agree 
not to borrow additional sums and would not spend over $350,000 on its plant 
without the permission of the banks. Salaries to the three principal officers were 
not to exceed $75,000 in total without permission of the banks. The company 
would agree to submit annual audit reports within three months of the end of 
each fiscal year and to supply unaudited quarterly balance sheets and operating 
statements. The company would further agree not to guarantee the debts of any 



90 Case Problems in Finance 

other organization or individual or to make any advances in excess of $25,000. 
The company would also agree not to merge, consolidate, or sell its business with- 
out permission of the banks. 

10. Certain events would be considered to constitute default on the loan. 
These included an entire change of management through the sale of stock, in 
which event the bank would be permitted to call the loan 60 days after it notified 
the company of its intention. The notes would become payable on demand in 
event of bankruptcy, receivership, or assignment for benefit of creditors or upon 
institution of any insolvency proceedings or if the company defaulted for 30 days 
on principal or interest or in any other covenant of the loan agreement. 



VV»A^VVVV\VVVVVVVVV\AV*\VVVVVVWA^VVVWVA^VVVVVVVWWVVVV\A\^^ 



Adanac Packaging Machine Company 



IW*V\VVVVVVVV\\VVWAVVVVVVVVVVVVUiVVWVVV\\\VVVVVVVVVWVVtV\^^ 



In January, 1947, at the request of the board of directors of the 
Adanac Packaging Machine Company, Mr. H. S. Cox, the treasurer, had 
discussed the advisabiUty of shifting the company's short-term bank loan 
to a term loan basis with Mr. Austin, a loan officer of the Industrial 
Bank. The interview is described more fully below. As a result of his 
talk with Mr. Austin, Mr. Cox was at work on pro forma statements to 
show the effect of anticipated events in the year ending December 31, 
1947. Also, since he had found Mr. Austin reluctant to enter a term loan 
arrangement, he was considering what to recommend to the directors 
with reference to the details of credit arrangements with the bank. 

The Adanac Packaging Machine Company was formed in 1910 by 
the current management. It had grown in large part by the reinvestment 
of earnings, although liberal dividends had also been paid. The company 
had developed outstanding packaging and labeling machines, which it 
supplied to the leading companies in the branded food industries. 

The restricted supply of these units during the war years, coupled 
with expansion of sales in the food industry, caused an unprecedented 
postwar demand for Adanac Packaging Machine Company products. 
Although shipments increased from $135,534 in January, 1946, to 
$740,314 in December, 1946, the balance of unfilled orders increased 
from $7,353,921 to $13,176,615 over this same period of time. The 
directors of the company felt that demand of this size was not destined 
to last for many years. Therefore, they were reluctant to increase the 
permanent capital of the business. They also wished to stop the three- 
shift manufacturing schedule that had been in effect. 

The order contracts were not cancelable and in addition carried a 
clause to the effect that quoted prices were subject to upward revision 
to cover any increases in costs that should occur before the time of ship- 
ment. 

91 



92 Case Problems in Finance 

The management felt that it was essential that this demand be satis- 
fied as quickly as possible in order not to encourage the development of 
competition. Therefore, it was decided to subcontract about $4,000,000 
out of a total of about $8,000,000 of forecasted sales for the year 1947 
in spite of the lowered profit margins that would result on these items. 
It was estimated this policy would increase cost of the subcontracted 
products as delivered to the Adanac Packaging Machine Company about 
9% over recently experienced factory costs in the Adanac plant. How- 
ever, the management decided not to increase prices because of this in- 
crease in costs. 

Arrangements had been completed with four manufacturing con- 
cerns to handle this subcontracted work. One concern had large cash 
reserves and required no financing. On the other hand, it was estimated 
that the three smaller subcontractors would require advances totaling 
$190,000 to finance their inventory and that these advances would con- 
tinue until the subcontracting program was completed. 

Even with the arrangements described, the company anticipated the 
continuance of a large volume of activity for well over a year. To assure 
its completion of the forecasted shipping schedule, the company em- 
barked upon a further building and renovation program, the cost of 
which was not expected to exceed $625,000. At the end of 1946, 
$50,000 of this $625,000 had already been expended, and the balance 
was committed for 1947 work. 

Since incorporation the company had enjoyed cordial relations with 
a very large bank which was able to lend many times the amounts which 
might be required by Adanac. The bank had always been very willing to 
give needed assistance to the company and had indicated its complete 
confidence in the management. 

In January, 1947, the Adanac company had been using bank credit 
for over a year. Mr. H. S. Cox, treasurer of the company, realized that 
the expansion program and the working capital needs of 1947 would 
require the company to obtain more funds. When the situation was dis- 
cussed by the board of directors, it was agreed that temporary financing 
should be sought from the bank. 

Whether this financing should be done on a short-term basis, as then 
was the case, or on a term basis or perhaps in part on a term and part on 
a short-term basis was a subject for considerable discussion. Mr. Alfred 
Davidson, general manager of the company, advocated that the bank 
loan be made a term loan. He recalled rather vividly the recession period 



Adanac Packaging Machine Company 93 

following World War I, when many banks refused to renew short-term 
loans. Some companies were forced into bankruptcy, while others had to 
liquidate their inventories at distress prices. Mr. Davidson argued that a 
term loan, being a definite arrangement, would prevent any such sudden 
action. The other directors, after hearing Mr. Davidson's argument, 
agreed with him and asked Mr. Cox to open negotiations with the com- 
pany's bank, the Industrial National Bank, with the view of securing a 
tentative term loan agreement. 

The next day Mr. Cox discussed with Mr. Austin, loan officer of the 
Industrial National Bank, the plans for the Adanac Packaging Machine 
Company. Mr. Austin first questioned the profitability of the coming 
year's operations. Mr. Cox replied that he expected the proportion of 
manufacturing costs to sales in the Adanac plant to remain about the 
same in 1947 as during 1946. On the other hand, the "cost of sales" of 
the subcontracted work was expected to be about 9 % higher. Overhead 
expense was expected to increase by 30% over the total of the previous 
year as a result of additional selling, clerical, and shipping costs neces- 
sitated by the increased sales. Although the income tax obligations of 
the company had been confused in recent years because of such proce- 
dures as renegotiation, it was thought that those uncertainties were past 
and that the company would be subject to the usual rate of 38% in the 
coming fiscal year. On these assumptions, taxes would be about $236,- 
000, and net profit after taxes $386,000. These figures were, of course, 
after depreciation, which would be about $100,000. 

Mr. Cox had said that he could not make a monthly cash budget 
with sufficient accuracy to be useful. Moreover, with the large backlog 
of orders, seasonal variations in shipments would not have to be con- 
sidered. He did agree, however, to prepare a pro forma balance sheet as 
at December 31, 1947, to show Mr. Austin the likely effect of the expan- 
sion of the Adanac plant and of the subcontracting program. 

On returning to his office and reviewing the December 31, 1946, 
balance sheet with reference to changes likely to occur during the forth- 
coming year, Mr. Cox decided that he should plan to set his cash balance 
at $625,000 to safeguard against any lag that might have to be financed 
between the time that payments were received from customers on prod- 
ucts manufactured by subcontractors and the time that payments had to 
be made to subcontractors for this same machinery. This cash would be 
in addition to the $190,000 advance to the subcontractors. 

Mr. Cox made a rough forecast that receivables might reach a peak 



94 Case Problems in Finance 

of $1,125,000, of which $125,000 would be offset by an accounts pay- 
able item to the subcontractors. He also thought that a further increase 
of $375,000 might occur in the inventory figures. U.S. government 
bonds were to be disposed of in the next few months to offset in part the 
cost of the new facilities. 

Mr. Cox was doubtful just how far he could expand the accounts 
payable but thought that probably those on account of goods made in 
the Adanac plant would remain at their current level. The tax liability 
would grow during the year to the amount of the calculated tax for the 
fiscal year. 

Dividends had been paid during 1946 on the preferred shares at the 
rate of 6% ($12,000) and on the common at $8.15 a share (about 
$120,000). Mr. Cox knew that the major stockholders, who were also 
among the management, would be very reluctant to reduce the common 
dividends and might desire larger ones if justified by earnings. On this 
point, Mr. Austin had said that it would be better to defer action on rais- 
ing the dividends until after the 1947 fiscal year ended, when operating 
results would be known. Even if they proved satisfactory, Mr. Austin 
had said that it would be desirable to discuss the matter with the bank 
before taking action to increase existing rates. 

During the interview with Mr. Austin, Mr. Cox had switched the 
topic of conversation to the bank's attitude towards a term loan. Mr. 
Austin had expressed reluctance to enter into a term loan agreement. 
He said he was willing to carry the company along on the present basis 
of 2^% unsecured notes with six-month maturities, so long as condi- 
tions remained favorable to the loan and interest rates did not stiffen. In 
fact, the bank would be pleased to finance the whole program on this 
basis. 

When Mr. Cox pressed Mr. Austin as to why the bank was reluctant 
to put the loan on a term basis, Mr. Austin replied that he thought Mr. 
Cox would not find much advantage in it. In the first place, the rate of 
interest would be 3% to 3i%, probably the latter. The bank would 
require the company to reduce the loan beginning at the end of the sec- 
ond or third year so as to pay it off by the end of 1954. Prepayments, of 
course, would be acceptable without penalty. 

Mr. Austin took pains to remind Mr. Cox that such a term loan 
agreement would incorporate a proviso requiring either that net work- 
ing capital be kept at a conservative amount or else that a suitable cur- 
rent ratio be maintained. There would also be included a limit on the 



Adanac Packaging Machine Company 95 

maximum current and noncurrent borrowings as well as a negative 
pledge clause in regard to all assets. In addition, payment of dividends 
and retirement of capital stock would be limited to not more than the 
amount of the earnings available since the date of the loan but within 
the limits on working capital that he had mentioned. Probably, Mr. 
Austin asserted, the bank would wish to limit increases in the gross 
amount that could be paid out in executive salaries. If any of these con- 
ditions should be violated, the whole term loan would be automatically 
due in 60 days. Summing up, Mr. Austin said that the purpose of all 
such restrictions was to preserve the company's financial position at the 
level it would reach shortly after the loan was extended and the proceeds 
of the loan had been put to use. 

Mr. Austin summarized his position by saying that he saw nothing 
to be gained by asking his bank to consider a term loan when it already 
had expressed willingness to arrange financing on an unsecured basis to 
any reasonable amount. But as the interview concluded, he said that he 
would be glad to discuss the matter further. Mr. Cox returned to his 
office and commenced to prepare the pro forma statements he had prom- 
ised Mr. Austin. He was confused as to what stand he should take before 
the board of directors on the question of the term loan as against the 
existing arrangement. 

Exhibit 1 shows the Adanac company's balance sheets for 1944, 
1945, and 1946. Exhibit 2 shows the operating statements for these 
years, and Exhibit 3 the operating record from 1936 to 1946. 



96 Case Problems in Finance 

Exhibit 1 

ADANAC PACKAGING MACHINE COMPANY 

Balance Sheets 

(Dollar figures in thousands) 

ASSETS 

Dec. 31 Dec. 31 Dec. 31 

1944 1945 1946 

Cash $ 921 $ 603 $ 464 

Notes and accounts receivable, net 207 518 1,011 

Inventories 803 1,060 1,676 

U.S. government bonds 726 819 516 

Postwar tax refund, payable in 1945 81 ... 

Total current assets $2,657 $3,081 $3,667 

Fixed assets, net 352 477 825 

Deferred charges and prepaid expenses 59 88 75 

Goodwill, patents, trademarks 1,000 973 952 

Patterns and drawings 28 41 63 

Postwar excess profit tax refund 28 ... ... 

Total assets $4,124 $4,660 $5,582 

LIABILITIES 

Notes payable — banks $ ... 

Accounts payable and accruals 529 

Reserves for taxes — accruals 43 

Due to U.S. government 77 

Total current liabilities $ 649 

Capital stock — 6% preferred 201 

Common, par $100 1,472 

Surplus 1,802 



$ 500 


$1,125 


565 


764 


98 


110 


$1,163 


$1,999 


201 


200 


1,472 


1,472 


1,824 


1,911 



Total liabilities $4,124 $4,660 $5,582 



Adanac Packaging Machine Company 

Exhibit 2 

ADANAC PACKAGING MACHINE COMPANY 

Operating Statements 

(Dollar figures in thousands) 

1944 

Sales, net $7,928 

Cost of sales* 6,583 

Gross profit $1,345 

Operating expenses 653 

Profit from operations $ 692 

Other income, netf 94 

Profit before taxes $ 786 

Provision for taxes 472 

Refund of prior years' excess profits tax 

Net profit $ 314 

Dividends paid 177 

* Includes amortization and depreciation $130 

t Includes royalties 73 



97 



1945 


1946 


$2,747 
2,097 


$4,354 
3,481 


$ 650 
605 


$ 873 
595 


$ 45 
78 


$ 278 
85 


$ 123 
50 
81 


$ 363 
144 


$ 154 
132 


$ 219 
132 


$136 
54 


$95 
40 



Exhibit 3 

ADANAC PACKAGING MACHINE COMPANY 

Operating Record 

(Dollar figures in thousands) 







Taxes on 


Net 




Earnings 


Year 


Sales 


Income 


Profits 


Dividends 


Retained 


1936 


$1,546 


$ 30 


$163 


$ 13 


$ 150 


1937 


2,501 


56 


302 


193 


110 


1938 


1,649 


16 


83 


102 


19ci 


1939 


2,544 


93 


407 


267 


140 


1940 


2,575 


72 


304 


177 


127 


1941 


2,783 


123 


338 


177 


161 


1942 


3,785 


701 


316 


177 


139 


1943 


4,064 


594 


289 


177 


112 


1944 


7,928 


472 


314 


177 


137 


1945 


2,747 


50 


154* 


132 


22 


1946 


4,354 


144 


219 


132 


87 



* Includes tax refund for prior years, $81,000. 
d Deficit. 



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Scott Laundry Company, Inc. 



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On June 1, 1944, James Scott, treasurer of the Scott Laundry Com- 
pany, Inc., read in the morning newspaper that the laundry plant of his 
company would soon be released from the control of the United States 
Army after a year during which the facilities had been operated by the 
Army. Upon inquiring from the responsible officials, Mr. Scott received 
confirmation of this report. He realized that the company was faced 
with urgent problems of re-establishing its civilian business and of fi- 
nancing its operations. 

Francis H. Scott had founded the Scott Laundry Company in New- 
ark, New Jersey, in 1910. Mr. Scott was in his middle seventies in 1944 
and, though he retained the office of president, the active management 
was in the hands of his two sons, Francis Scott, Jr., vice-president (in 
charge of operations ) , and James Scott, treasurer and secretary. The two 
sons had joined their father in the enterprise in the early 1920's. 

During the 11 years from 1931 through 1941, the volume of busi- 
ness done by the company had grown steadily, net sales increasing from 
$206,600 in 1931 to $445,308 in 1941. Substantial profits had been 
earned, ranging from a low of $19,900 after taxes in 1931 to a high of 
$40,600 after taxes in 1939. A large portion of the profits was paid out 
in dividends. The capital stock of the company, all of which was owned 
by members of the Scott family, had not been increased during this 
period. 

James Scott attributed the steady growth of the business principally 
to a merchandising plan which he had devised in 1933, a depression 
year. At that time he found that the size of an average family laundry 
in the residential area of Newark and neighboring communities served 
by the company was about 20 pounds a week but that, except for the 
"wet wash" service, the laundry bundles typically were well below this 
weight, an indication that housewives were not sending out the entire 

98 



Scott Laundry Company, Inc. 99 

household laundry. He also found that the size of the bundles tended to 
decrease directly in proportion to any increase in the price charged for 
the particular service. Up to that time, the company had followed the 
customary practice in the industry and charged at varying rates; for ex- 
ample, from 7 cents to 20 cents a pound according to the type of finish 
for the particular article such as "rough dry," "flat," or specially finished 
as in the case of shirts and blouses. 

As a result of his studies, Mr. Scott became convinced that the 
method of pricing at different rates deterred housewives from sending 
out all the family laundry. To correct this situation Mr. Scott wished to 
offer his customers a service at the lowest possible basic price a pound 
that would permit the company to operate at a profit. Such a price would, 
he thought, prevent the "splitting of the bundle" and insure a normal 
ratio in each bundle between household articles that required only a 
rough dry or flat finish and wearing apparel that required a more com- 
plicated process of finishing. After some experimentation Mr. Scott 
therefore instituted what he called the "family bundle," with a mini- 
mum charge of $2 for 20 pounds and a charge of 10 cents for each addi- 
tional pound regardless of the type of finish required by the various 
articles included in the bundle. The resulting major increase in volume 
came from the larger unit of sale to those customers who theretofore 
had used the semifinished services. 

Mr. Scott was proud of the fact that the company's volume expanded 
steadily during the depression years. Furthermore, he believed that upon 
the re-establishment of the business after the plant was returned by the 
Army the same principle of volume service at low prices should be con- 
tinued, although he recognized that costs were higher and that the price 
of the family bundle would have to be increased to some extent. 

By 1942 the continued expansion in business had necessitated major 
additions to the company's buildings and an expenditure of $50,000 for 
new equipment. In consequence, the company had to borrow a relatively 
large amount, $75,000, from its bank, the Seaboard Trust Company. 
Even this amount had not been sufficient to permit the company to pay 
all its trade creditors promptly. By the time the plant was commandeered 
in the spring of 1943, there were a number of overdue trade accounts 
payable while a substantial sum also remained owing to the bank. 

At the time the Army took over the plant Mr. Scott had an appraisal 
of the property made in order to determine a basis for the rental to be 
paid by the Army. The appraisal indicated that the plant should be val- 



100 Case Problems in Finance 

ued at $275,000 on the basis of reproduction cost new less depreciation. 
The appraisal company further indicated that the Army's payment 
should take into account costs estimated at $120,000 which had been 
incurred in training the company's staff and in building up a customer 
clientele, since it was anticipated that these costs would have to be re- 
incurred in re-establishing the business after the plant was returned 
from Army operation. The appraisal company considered 1 5 % per an- 
num a fair rate of rental on the fixed assets and 33t% per annum as the 
proper rate at which to write off the costs of building up the company's 
staff and customers. On this basis the appraisal company arrived at 
$81,250 as the estimated fair annual rental for the property. This esti- 
mate, however, was not accepted by the government and an annual rate 
of $40,000 was established. The management was forced, under a court 
order, to turn over the facilities on the Army's terms. Mr. Scott planned 
to go to the United States Court of Claims for additional compensation. 

The rental during the year 1943 was not sufficient to liquidate any 
large part of the liabilities created by the expansion in 1942, as will be 
seen from the March 31, 1944, balance sheet shown in Exhibit 1. 

The mortgages for $53,000 and $15,000 held by the bank were 
secured by all the plant and equipment used in the enterprise. In addi- 
tion, insurance policies with a cash surrender value of $41,638 were 
pledged as security for the bank loan. The policies insured the lives of 
each of the two Scott sons for $75,000; their estates were named as 
beneficiaries. The notes and loans payable, totaling $13,176, included 
about $3,000 due to trade creditors and $10,000 advanced from per- 
sonal funds of the Scott family. In order to make these advances the 
members of the Scott family had mortgaged their homes in 1942. 

The debenture sinking fund certificates, totaling $21,800, were held 
by trade creditors. The certificates had been issued to certain trade cred- 
itors in 1943 before the Army took over in settlement of overdue ac- 
counts payable. The certificates bore a 5 % noncumulative interest rate, 
payable only if earned, and were convertible into preferred stock, at the 
holder's option, after five years. Under their terms the company agreed 
to set aside 7 5 % of net income for payment of the principal of the cer- 
tificates. The holders agreed to subordinate the certificates to the mort- 
gage notes which were held by the bank. 

Early in 1942 the company had experienced difficulty in retaining 
its personnel because of the high wages paid by war plants in the vicin- 
ity. In spite of increases in piece rates, turnover in the labor force became 



Scott Laundry Company, Inc. 101 

as high as 200% in a three months' period in 1942. Price controls made 
it impossible to increase the charges for laundry so that the margin of 
profit had narrowed as shown in Exhibit 2. By the end of the year of 
operation by the Army the labor force was almost completely new and 
the piece-rate method of compensation had been replaced by an hourly 
wage at a high rate. The efficiency of the labor force, moreover, had de- 
creased greatly because of the irregularity of the work. Consequently, 
Mr. Scott believed that the selection of a skilled and efficient labor force 
was one of the key problems to be faced. 

Mr. Scott realized that a large volume of profitable civilian business 
could not be regained immediately because of the shortage of labor, de- 
livery equipment, and trained route men, but he counted on three 
sources of business to enable him to resume operations on a profitable 
basis. A chain of retail laundry stores which for the most part had been 
closed during the war wanted to reopen if he would take their laundry 
and cleaning work. Also, near-by summer hotels were opening and these 
old customers could be counted upon for a substantial volume. In addi- 
tion he expected the company's own store located in the laundry to pro- 
duce a good volume of business as it was situated on a main route from 
Newark to several populous suburbs. For some months, at least, this 
store would have a further advantage in that the laundry could finish 
work several days more quickly than its competitors. Mr. Scott estimated 
that these three sources of business would enable him to open his plant 
and employ all the available good help. He expected that sales would 
total approximately $5,000 per week, made up of $2,150 to the laundry 
chain, $1,350 to summer hotels, and $1,500 in the company's store. 

While it was impossible to get recent operating figures from the 
Army, Mr. Scott had prepared figures from the annual statistics of the 
American Institute of Laundering. He realized that his firm was not en- 
tirely typical but thought that the computation, shown in Exhibit 3, 
might be a guide. 

It was evident to Mr. Scott that additional cash would be necessary 
before the company could resume operations. He estimated that at least 
$7,000 would be necessary for working capital and an additional 
$10,000 would be desirable for purchasing laundry supplies which the 
Army had accumulated and which could be acquired at advantageous 
prices. He therefore decided to ask his bank to lend an additional 
$17,000 for these purchases. 

Mr. Scott had some misgiving about the bank's willingness to in- 



102 Case Problems in Finance 

Exhibit 1 

SCOTT LAUNDRY COMPANY, INC. 

Balance Sheet 

March 31, 1944 

ASSETS 

Cash $ 3,113 

Accounts receivable 1,566 

Current assets $ 4,679 

Land and buildings $146,292 

Machinery and equipment 207,952 

$354,244 

Allowance for depreciation: 

Buildings 53,834 

Machinery and equipment 121,372 179,038 

Cash surrender value of life insurance (pledged under 

mortgage note) 41,638 

Investments (treasury stock) 7,300 

Prepaid items 692 

Total assets $233,347 

LIABILITIES 

Notes payable $ 6,176 

Loans payable 7,000 

Accrued expenses 225 

Current liabilities $ 13,401 

Advances from officers 5,950 

Reserve for taxes 1,009 

Reserve for compensation losses 4,551 

Mortgages payable to banks: 

Real estate 53,000 

Chattel 15,000 

Debenture sinking fund certificates 21,800 

7% cumulative preferred stock 30,000 

Common stock 20,000 

Surplus 68,636 

Total liabilities and net worth $233,347 



crease its loan. In the early years of the company's history the relation- 
ship with the bank had been cordial, but since about 1925 Mr. Scott had 
sensed a changed attitude. At that time the controlling stock of the bank 
had been purchased by a larger bank in Newark and management pol- 
icies had been determined by the directors of the larger institution. In 
Mr. Scott's opinion the loan officer had become more conservative in his 
judgment of loan risks and less aggressive in searching for new loans. 
For example, the loan officer had never inquired whether the bank 



Scott Laundry Company, Inc. 103 

Exhibit 2 

SCOTT LAUNDRY COMPANY, INC. 

Income Statements 

1941 1942 

Net sales $445,308 $453,176 

=: : — 3 

Productive labor $ 97,645 $152,947 

Productive supplies 44,563 43,788 

Power 33,832 33,242 

Plant overhead 62,772 61,678 



Laundry operating costs $238,812 $291,655 

Collection and delivery 87,229 71,200 

Sales promotion 13,247 13,039 

Executive salaries 22,373 21,983 

Office and administrative 33,515 32,931 



Total costs $395,176 $430,808 

Net profit before taxes 50,132 22,368 

Income taxes 15,220 13,637 

Net profit after taxes $ 34,912 $ 8,731 



Exhibit 3 

SCOTT LAUNDRY COMPANY, INC. 

Estimated Income Statement for Renewed Operations 

Net sales $250,000 

Productive labor $ 85,700 

Productive supplies 22,500 

Power 7,500 

Plant overhead 32,400 

Laundry operating costs $148,100 

Collection and delivery 44,175 

Sales promotion 8,300 

Executive salaries 8,650 

Office and administrative 18,100 

Total costs $227,325 

Net profit before taxes $ 22,675 

might finance any purchases of new equipment although the rates 
charged by the finance companies for such financing were considerably 
higher than the bank received on its regular commercial loans. The 
large amount of collateral which had been demanded to secure the exist- 
ing loan was, in Mr. Scott's opinion, further evidence of the loan officer's 
conservative attitude. 

Mr. Scott recognized also that the prospects for an additional loan 



104 Case Problems in Finance 

might be reduced by the company's failure to repay the existing loan as 
rapidly as was originally contemplated. When the loan was arranged 
monthly payments of $1,000 were agreed upon, but the Army's rental 
payments had been too small to allow Mr. Scott to continue payments 
at that rate, and the monthly payments had been reduced to $500. 

Mr. Scott had for many years submitted financial statements to the 
bank at the end of the company's fiscal years and had periodically dis- 
cussed the company's affairs with the loan officer. He had explained to 
the loan officer the reasons why it was not possible to reduce the loan 
more rapidly while the Army operated the plant and had given him a 
copy of the appraiser's report at the same time. Mr. Scott believed that 
the company's earning record over a period of years was adequate evi- 
dence of the management's ability. Moreover, his reputation as a leader 
in the community was well known to the bank, since he had held a 
number of prominent positions locally, including the presidency of the 
Newark Chamber of Commerce. 

In accordance with his decision to seek aid from his bank, Mr. Scott 
called at the bank, explained the reasons for the company's need to in- 
crease the loan, and outlined in general terms his plans. After listening 
for an hour, the loan oJSicer said he regretted that he could not agree to 
increase the loan and suggested that Mr. Scott find sufficient trade credit 
to permit resumption of operations. 

The brusque manner of the loan ofi&cer at the Seaboard Trust Com- 
pany came as quite a surprise to Mr. Scott. Almost before he left the 
bank, he decided to transfer his banking business to another institution 
as soon as possible. That evening he talked the matter over briefly with 
a neighbor, who was a teller in the Market Street National Bank, an- 
other bank in Newark. This man said that his bank was interested in 
expanding its business with local concerns and that he would ask one of 
the officers to get in touch with Mr. Scott. 

During the following morning, Mr. Scott received a telephone call 
from Mr. Bernstein, assistant cashier of the Market Street National 
Bank, who said that he had had an outline of the situation from the 
teller, that it "sounded like a loan," and that he was anxious to see Mr. 
Scott. An appointment was made for the following afternoon. As the 
conversation closed, Mr. Bernstein suggested to Mr. Scott that he should 
bring with him some figures and ''anything else of interest to the credit 
department" for the folder that Mr. Bernstein would set up on the 
Scott Laundry Company. 



t\VVVVVVVVVVVVVVVVV>^V^^AAAA^\VVVVVVVVVVVVWVVVVV>MAA^^V^^ 



Haward Manufacturing Company, Inc. 



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In July, 1940, Mr. Ralph Haward, treasurer of the Haward Manu- 
facturing Company, was considering how to finance the forthcoming 
season. The company was a well-known manufacturer of high-grade 
children's heavy winter outerwear. It had been in the hands of the 
Haward family for over 40 years. Once amply financed, the company 
had had a series of unfortunate years since 1936 which had made it nec- 
essary for it to secure financial aid to continue in business. The 1939 
season had been financed with great difficulty. 

The manufacturing operations of the Haward Manufacturing Com- 
pany, Inc., were highly seasonal. Active work usually commenced in 
May or June and continued until November or December. In the late 
spring the company planned the financing for the forthcoming season. 
The company's customers, large and reliable retail organizations, would 
not accept delivery or pay for the merchandise until early fall. They 
were willing, however, to place their orders during the spring and sum- 
mer if the Haward Manufacturing Company would undertake to meet 
lowered prices if offered by competitors at the time of delivery. Terms 
of sale were 2%, 10 days, E.O.M. for the larger sizes and 8%, 10 days, 
E.O.M. for the infant sizes with all shipments made before September 1, 
dated as of that date. These discounts usually averaged 5 % of sales. 

The financing problem created by production, which began during 
the late spring, had been met for many years by the willingness of the 
fabric suppliers to bill spring and early summer shipments of their goods 
"60 days July 1." This gave up to four months' credit to the company 
on its purchases. The principal cash requirement of the production pe- 
riod was, therefore, for the payrolls. This need had been financed with- 
out difficulty until 1937. 

105 



106 Case Problems in Finance 

The financial difficulties which culminated in 1939 and 1940 arose 
as follows: 

During 1936 and the early part of 1937 the company erected a new 
building and made improvements on buildings already owned and occu- 
pied. These expenditures amounted to about $22,000. When the work 
was about to begin, the company's bank had been asked to make a long- 
term loan secured by a mortgage on the property. This would increase 
the mortgage loan made by the bank when the property had been pur- 
chased some years previously. The officer interviewed had seemed favor- 
ably impressed with the loan request but suggested that the improve- 
ments be completed first and then the loan be arranged. With this in- 
formal understanding, the construction was completed in the summer of 
1937. By this time, however, business conditions in the garment indus- 
try were unfavorable, and the bank refused to increase the mortgage 
loan. 

Owing to mild weather, the fall of 1936 had not proved a good sell- 
ing season for winter clothing. The retail trade, therefore, had a large 
carry-over of such merchandise to the 1937-1938 season. In the spring 
and summer of 1937, when the Haward company attempted to sell its 
fall lines, it discovered that most stores had on hand a heavy inventory. 
It was also learned that sales resistance to Haward products was very 
high, as many garments had proven unsatisfactory during the past sea- 
son because of hidden defects in the fabric used. The retailers had had to 
take back a number of the garments from their customers. This situa- 
tion necessitated Haward's reimbursing the retailers for the goods re- 
turned. In turn, the Haward Manufacturing Company sued the mill 
which supplied the inferior fabric, but as of July, 1940, settlement had 
not yet been made. The expense of indemnifying the retailers proved to 
be small, but the effect of this poor merchandise on the good will of the 
concern was very damaging. Lagging sales in the fall of 1937 resulted 
in an inventory carry-over into 1938 of $42,000 as compared to the 
previous year's carry-over of $18,000. 

When it became apparent that the Haward company would be 
forced to carry the large inventory into 1938, it was realized that the 
accounts payable could not be liquidated when due. Mr. Haward was 
able to persuade the majority of the creditors to defer their claims by 
promising payment in full within a year. However, difficulty was en- 
countered when one principal creditor was asked to consent to defer- 
ment. The concern itself appeared to be willing to defer the amount 



Haward Manufacturing Company, Inc. 107 

owing to it, but the insurance company which guaranteed its accounts 
receivable asked that the matter be cleared up immediately and agreed 
to settle for 25% of the amount owing. Even to make this settlement, 
the Haward Manufacturing Company was forced to sell to the govern- 
ment^ $60,000 cost value of inventory for about $14,500. This action 
depleted still further the company's resources, leaving it with $32,400 
in deferred claims to be settled. 

The situation became more complicated when the problem of fi- 
nancing the 1938 season was faced. The credit losses of fabric suppliers 
had been so widespread during the previous year that they refused to 
grant credit beyond 30 days. Thus the Haward company had to provide 
funds in advance of collections not only for payrolls but also to purchase 
fabric. A 5%, $6,000 bank loan was arranged, but the principal stock- 
holders pledged their personal securities as collateral for this loan. This 
loan v/as paid in the fall, but inventory figures were kept very low. 

During the next season, 1939-1940, the company had very little 
liquid funds to carry on the business. Operations were carried on in a 
hand-to-mouth manner. The bank advanced $12,000; yet it was neces- 
sary to arrange a 5%, $2,400 loan on the personal endorsement of the 
principals with a small co-operative loan agency. This loan was to be 
reduced by $200 per month. Funds were so limited during this period 
that the management decided not to do the usual sales promotion work. 
The low sales experienced in 1939 were thought to be due in part to 
this policy. 

But, during the fall of 1939 and spring of 1940, the company was 
able to promote its line in an unusual way. A revolving type of display 
was placed in front of seats placed for rest purposes at the New York 
World's Fair. This display pointed out the desirable features of the 
Haward products. Order blanks were available so that onlookers could 
place orders on the location. The company planned to fill these orders 
through a retailer in the area where the customer lived, and thus estab- 
lish new retailer contacts. The cost of this display, $1,100, was paid in 
advance out of the personal funds of Mr. Haward. The $2,000 cost of 
printing the necessary literature to go along with the display was ar- 
ranged by friends of Mr. Haward on his personal guarantee. 

By July, 1940, toward the end of the usual selling season, Haward 

^Unsettled conditions were so general in the garment manufacturing industry that 
the government purchased some $50,000,000 of merchandise for $15,000,000 for relief 
purposes. 



108 



Case Problems in Finance 



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Haward Manufacturing Company, Inc. 1 09 

Manufacturing Company, Inc., had $90,000 sales value in firm orders 
at good prices from large and reliable retailers which were listed by the 
credit agencies as AAl accounts. Sufficient orders were now on hand for 
about four months' normal operation. The war in Europe had been go- 
ing on for 10 months, and as a consequence economic conditions in the 
United States were quite buoyant. The management of Haward Manu- 
facturing Company was confident that conditions now looked better for 
the company than they had in the past several years. They felt that the 
$90,000 orders already on the books gave assurance of a reasonably 
profitable season. 

The management had kept complete records of the cost of making 
and selling each type of garment. The accountant had estimated the cost 
per garment for the fall of 1940 as follows: 

Material cost (goods in style for 1940-1941 season) $2.35 

Direct labor 1.35 

Administrative and selling 1.05 

Total $4.75 

Average selling price 7.00 

$2:25 

5 % selling discount 0.35 

Profit per unit $1.90 

He also made up a projected statement of cash receipts and payments 
for the season, which is shown in Exhibit 1 (p. 108 ) . It does not include 
the possible receipts and disbursements related to the existing working 
capital position, and it excludes the salaries of the Haward brothers, 
who agreed to defer them until after the end of December. Exhibits 2 
and 3 present recent financial statements of the company. 

Toward the end of July, 1940, the company had a negative working 
capital position as shown in Exhibit 2. While the balance sheet valua- 
tion of the machinery was less than $6,000, it had been estimated that 
it was worth $24,000, with a quick sale value of $15,000. The buildings 
and real estate were carried on the balance sheet at $31,000 but had an 
appraised value for real estate taxation purposes of $48,000. The com- 
pany still had a mortgage of $5,280 on the property. In spite of the ap- 
parent surplus mortgageable value that existed in this property, because 
of the great amount of loft space available at very reasonable rates in 
the city where the Haward Manufacturing Company, Inc., was located, 
it was impossible to secure funds by further mortgaging the property. 

The fabric used by the company was of the highest grade and was 
considered a staple item. Before it was cut, it probably had a quick resale 



110 Case Problems in Finance 

Exhibit 2 

HA WARD MANUFACTURING COMPANY, INC. 

Balance Sheet as of December 31, 1939 
AND Working Capital Position, July 25, 1940 

ASSETS 

December 31 July 23 

1939 1940 

Current assets: 

Cash $ 3,982 $ 654 

Accounts receivable $ 9,924 

Less: Reserve 164 9,760 2,600 

Inventories : 

Finished and in process $ 3,953 1,641 

Raw materials 7,818 .... 

Trimmings 2,984 14,755 

Investments (pledged) 9,745 9,745 

Total current assets $38,242 $14,640 

Furniture, fixtures, and machinery $ 8,497 

Less: Depreciation 2,159 6,338 

Land and buildings $33,816 

Less: Depreciation 2,430 31,386 

Other assets 1,218 

Total assets $77,184 



liabilities 

Current liabilities: 

Accounts payable — current $ 8,068 $ 3,052 

Notes payable — bank, secured 12,000 12,000 

Notes payable — trade 2,400 500 

Co-operative credit agency 1,400 .... 

Payroll and commissions 358 .... 

Total current liabilities $24,226 $15,552 

Mortgage payable 5,280 

Owing officers for salaries, etc 1,484 

Federal income tax .... 

Capital stock 48,840 

Surplus 2,646 ^^ 

Total liabilities $77,184 

<* Deficit. 

value of 90% of its current market. The cloth could be purchased on a 
hand-to-mouth basis, but substantial savings, perhaps as high as 8%, 
could be gained by making large quantity purchases. In making up his 
cash budget for the fall of 1940, Mr. Haward assumed large-scale pur- 
chases. Once the fabric was in the plant it took about three to four weeks 
to manufacture it into garments and to ship it out. 



Haward Manufacturing Company, Inc. Ill 

■ Exhibit 3 
HAWARD MANUFACTURING COMPANY, INC 
Income Statements 

. 1958 ^ ^ 1939 ^ 

Gross sales $144,641 $102,415 

Less: Returns 13,937 $128,704 8,110 $94,305 

Cost of sales: 

Material cost $ 90,300 $ 49,938 

Labor 20,354 18,743 

Factory expense 1,408 1,668 

Freight and carting . . . 1,228 113,290 846 71,195 

Gross profit $ 15,414 $23,110 

Overhead expenses* 32,684 26,652 

$ 17,270'* $ 3,542<* 

Other income 676 600 

Sales discount, etc 6,906^* 7,764* * 

Net profit for period $ 23,500** $10,706"* 

Beginning surplus 1,558 o, )60 

Donated surplus 14,212 .... 

Gain from settlement of ac- 
counts payable 15,790 ... . 



Ending surplus $ 8,060 $ 2,646*^ 



* Includes: Salaries of 3 Haward brothers $12,216 $10,308 

Depreciation charged 

d Deficit. 



The management had delayed putting into production the orders 
that had been secured through the World's Fair because of the lack of 
funds. The chief owners had no further personal assets that they felt 
they could risk in the business and some of them were interested in free- 
ing the collateral that they had provided. 

The company was facing a crucial period, but Mr. Haward was sure 
that it could be put on a successful basis again if only short-term financ- 
ing could be obtained to handle the $90,000 of orders that had been 
secured. 

Mr. Haward was not deeply concerned over his own welfare as far 
as the future of the company was concerned. He was confident that if his 
efforts to put this concern on a profitable basis were not successful he 
could always secure employment which would be as remunerative as this 
company had been to him in the past. However, he did feel that he had 
responsibilities toward his two brothers who were in the company and 
who were mainly concerned with the production aspects of the business. 



PART 2 

FINANCING LONG-RUN NEEDS 



i 



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Slater Quarry Corporation 



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In the fall of 1935, Mr. W. B. Slater, the owner of a fairly large 
New England farm, discovered by accident that a wide vein of slate, ap- 
parently of excellent quality, ran across a portion of his farm which he 
had always regarded as barren and of little value. After some prelimi- 
nary inquiries with regard to the market demand for high quality slate 
and to the existing sources of supply, he became very much interested in 
the possibility of opening a quarry on his property and extracting, proc- 
essing, and marketing the slate. He realized that this enterprise would 
require financing in an amount substantially in excess of his own re- 
sources, but he was confident that the necessary financing could be ob- 
tained if he was able to make a sufficiently favorable showing with 
regard to the prospects of the enterprise. 

Mr. Slater had a few thousand dollars of savings which he drew on 
rather heavily for the expenditures which appeared to be necessary to 
demonstrate the commercial practicability of his project. The major ex- 
pense was incurred in testing the extent and quality of the slate deposit 
by diamond drilling. The report on the test drillings indicated consider- 
able amounts of heavy slate free of pyrites, and so of electrical grade, 
relatively near the surface; and larger quantities of structural grade. The 
topography was such as to provide adequate drainage. Sand and stand- 
ing timber, useful, respectively, for finishing operations and for crating, 
were available in the neighborhood. The farm was within 15 miles of 
a railroad. 

Mr. Slater also made extensive investigations with regard to the 
methods employed in other slate quarries, the kind and amount of equip- 
ment that would be required for his project, the costs of operations, sell- 
ing prices, marketing conditions, and similar matters. He learned that 
known slate deposits of the highest quality were few in number and that 

there was a good demand for slate of that quality for switchboard use in 

115 



116 Case Problems in Finance 

the plants of electric light and power companies, telephone companies, 
and all others using electric switchboards, and also to a lesser extent for 
tables, shelves, and sinks, especially in chemical laboratories, and for 
miscellaneous uses. He also learned that slate of lower but still mer- 
chantable quality found its principal use in the form of roofing slate, 
while the smaller fragments and odds and ends that would otherwise be 
waste found a fairly extensive, though not very profitable, market in the 
form of flakes to be used in coating asphalt shingles. 

These investigations made it clear to Mr. Slater that his proposed 
quarry could be operated most profitably if, in connection with it, he 
built a small mill for working the slate into the forms in which it could 
be most advantageously marketed. He estimated that to provide hoisting 
and other equipment for the quarry, to build the mill to the full capacity 
which he contemplated including such equipment as saws, planers, and 
splitting machines, and to cover operating and miscellaneous expenses 
during the period required to open the quarry, develop the market for 
the product, and place the enterprise on a self-supporting basis would 
call for a cash investment of about $100,000. The full equipment re- 
quired for the quarry, however, would not be needed until some depth 
had been attained; and he was fortunate in the fact that the merchant- 
able slate, as indicated by the diamond drilling, came very near the sur- 
face in considerable quantity. He also proposed to start with a mill of 
somewhat smaller capacity than ultimately contemplated and to add ad- 
ditional mill equipment as the market was developed and the production 
of the quarry increased. With the initial expenditure thus reduced, he 
estimated that the cash capital required at the outset would not exceed 
$75,000. 

On the basis of these estimates, Mr. Slater proposed to form a corpo- 
ration, to be known as the Slater Quarry Corporation, to which he would 
transfer that portion of his farm containing the vein of slate, with 
enough adjoining land for all operating purposes, receiving in return 
from the corporation $100,000 par value of its capital stock. It would 
then be necessary to raise the $75,000 of additional capital required. 

At this point in the development of the project, in the summer of 
1936, Mr. Slater decided to visit an acquaintance, Mr. John Bannister, 
who was the president and principal stockholder of the bank in the 
neighboring county seat and also a man of considerable private means. 
He knew that Mr. Bannister had interests in several successful enter- 
prises in the area and thought that he might be interested in investing 
in the new company. 



Slater Quarry Corporation 117 

At a brief preliminary discussion with Mr. Bannister, Mr. Slater de- 
scribed the deposit and, in general terms, his plans for a concern to ex- 
ploit it. Mr. Bannister appeared somewhat interested in the project and 
expressed a desire to look over fairly carefully Mr. Slater's material re- 
garding the nature and extent of the deposit and his estimates of the 
expense and income that might be expected for the suggested concern. 
Accordingly, Mr. Slater left some of the material with Mr. Bannister. 

A week later Mr. Slater received a telephone call from Mr. Ban- 
nister. Mr. Bannister stated that he was inclined to agree as to the profit 
possibilities in good years but that it had been his experience that a new 
concern such as Mr. Slater proposed could expect to encounter difficul- 
ties in the manufacture and sale of its products, even if the raw material 
supply were excellent. Subject to the confirming report of an independ- 
ent check on the deposit of slate, however, Mr. Bannister stated that he 
would be interested in discussing further the possibility of his investing 
substantially in the new corporation. 

Mr. Slater was much encouraged by this reaction and was led to the 
hope that Mr. Bannister could be persuaded to furnish all of the $75,000 
of cash capital initially required. In regard to arrangements, Mr. Slater 
seriously considered four major possibilities. As he thought about these 
possible arrangements, he endeavored to reach some conclusions as to 
the advantages and disadvantages of each arrangement from his own 
point of view and also as to how Mr. Bannister might be expected to 
react to each of the proposals if they were offered him. 

The four arrangements Mr. Slater had in mind were as follows: 
The first was a $75,000 bank loan, for which the company would pay 
such rate of interest, not exceeding 5%, as Mr. Bannister might decide 
to charge. The second was for the bank or Mr. Bannister to buy at par 
an issue of $75,000 par value of 5 % bonds, to mature in 20 years, with 
a sinking fund beginning to operate after the first five years through 
which two-thirds of the total issue would be retired before maturity in 
equal annual installments. The third was an issue of $75,000 par value 
of 6 % cumulative preferred stock, to be purchased by Mr. Bannister at 
par. Such preferred stock would have equal voting power with the com- 
mon, share for share; but since both common and preferred were to be 
in shares of $100 par value, it was evident that the common stock would 
have a majority of the votes. The fourth was the sale to Mr. Bannister at 
par of an additional $75,000 par value of common stock, thus giving 
the company a total stock capital of $175,000, all of one class, with no 
bank loans or funded debt. 



118 Case Problems in Finance 

Mr. Slater's estimates indicated that, with the initial equipment 
which he proposed and as soon as the operations of the company were 
well established, it should be able to earn from $17,500 to $20,000 a 
year before interest and income taxes/ Under any one of the four ar- 
rangements, Mr. Slater's plan contemplated that dividends on the com- 
mon stock in the early years should be held to a low figure and that from 
$8,000 to $10,000 a year should be retained out of earnings and in- 
vested in equipment, until provision had thus been made for the $25,000 
of additional equipment which, according to his estimates, would ulti- 
mately be needed. With this increased investment, Mr. Slater estimated 
that earnings could be expanded to an average level ranging from 
$20,000 to $25,000 a year. It was estimated that the supply of slate in 
the quarry would last at least 50 years. 

^ The federal corporate income tax rate in 1935 was 13|% and in 1936 was 13% 
on net corporate incomes in the bracket $15,000-$40,000. In 1936 in addition there was 
an undistributed profits tax, which can be ignored by the student. 



(VVV\VVVVVVVVVVVVVVVVVVVVVVV\AVVV\\VVVVVVVWiVWWWV\VVVVVV^^ 



Longstreet Machine Company 



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On the morning of December 17, 1945, the board of directors of 
the Longstreet Machine Company was scheduled to meet for the purpose 
of considering two pending proposals for raising funds: one, a term 
loan; and the other, a public issue of common stock. 

The Longstreet Machine Company, located in Springfield, Massa- 
chusetts, had manufactured textile twisting machinery since I860. Man- 
agement had remained in the Longstreet family. Currently, Richard 
Longstreet, grandson of the founder, was president; the latter's elder 
son was vice-president and sales manager, and another son was assistant 
to the plant manager. The company's stock was closely held, 65 % being 
owned or controlled by the Longstreet family. The rest was held by offi- 
cers and employees and a small number of individuals, estates, and char- 
itable institutions. 

The company produced 15 different types of machines. The great 
majority of the parts, however, were used in more than one type of ma- 
chine. Normally, parts were manufactured for inventory in accordance 
with estimated needs. As sales were reported, assembly orders would be 
issued and the required parts withdrawn from inventory. Machines were 
not carried in stock and parts were not, as a rule, manufactured for spe- 
cific orders. A substantial proportion of dollar sales, 35% in the five 
years preceding World War II, consisted of replacement parts. 

Inventories were normally large and, since production of parts was 
based on forecasts of sales, would at times become excessive or unbal- 
anced. In periods of declining business, many months would elapse be- 
fore inventories could be reduced proportionately. During the five years 
ending in September, 1941, inventory averaged 40% of annual sales 
and 65% of current assets; finished parts varied from 46% to 68% of 
total inventory. 

The greater part of the company's sales were made by its own sales 

119 



120 Case Problems in Finance 

force. Sales offices were maintained in principal textile centers in this 
country and Great Britain; and in peacetime, traveling sales representa- 
tives served Europe, South America, Asia, and Australia. Fifty per cent 
of dollar sales prior to the war were made for foreign shipment, a far 
larger percentage than was characteristic of any of the company's com- 
petitors. Terms of sale were net/30 days to domestic customers and by 
letter of credit or 30-, 60-, or 90-day draft, with bill of lading attached 
on foreign shipments. 

The company had been profitable but, typical of manufacturers of 
producers' goods, earnings were subject to considerable cyclical varia- 
tion. Sales during the depression years of 1930 and 1931 declined 40% 
below the amount for the 1929 calendar year, resulting in substantial 
operating losses. Because of the specialized nature of the greater part of 
its inventory and because it was impossible to foresee how long the de- 
pression would last, inventories were not reduced proportionately to 
declining sales. In fact, inventories increased more than 5 % during the 
fiscal year ending June 30, 1931. The losses of 1930 and 1931, com- 
bined with the failure to liquidate inventory and with sinking fund 
($90,000 a year in the period 1927-1929 and $115,000 a year from 
1930 to 1932) and interest requirements on a 7% bond issue, led to 
acute financial difiiculties. 

Late in 1930, Mr. Longstreet arranged to borrow $75,000 each 
from five banks, three located in Boston and the other two in Springfield 
and New York. In the second quarter of 1931, two of the Boston banks 
called their loans, and for a time it appeared that the others would fol- 
low suit. Mr. Longstreet, however, succeeded in persuading the remain- 
ing banks to renew their loans, and in the spring of 1932 the Pine Street 
National Bank, the company's New York bank, lent an additional 
$500,000. Following the 1933 upturn in the business cycle, the com- 
pany's finances improved steadily. The bond issue was retired at its ma- 
turity in 1935 from the proceeds of additional bank borrowing. The 
company remained in debt to the banks thereafter, but the amount of its 
borrowings varied. In March, 1941, a $900,000, 2|%, five-year term 
loan was arranged with Pine Street National Bank for the purpose of 
liquidating outstanding notes and supplying additional working capital 
necessitated by defense contracts. 

During World War II military contracts accounted for approxi- 
mately half the company's volume. The remainder of its output con- 
sisted of twisting machinery and replacement parts, with the latter pre- 



LONGSTREET MACHINE COMPANY 121 

dominating. No major changes in plant or equipment were required by 
military production; so the company experienced no plant reconversion 
problems when its last war contract terminated in August, 1945. 

The company's management considered postwar sales prospects to 
be favorable. By December, 1945, its backlog of domestic orders had 
reached $5,000,000. Management also anticipated a large volume of 
foreign sales after world political and economic order was restored. 

The management was concerned, however, about the longer-term 
outlook. Fostered by corporate income tax rates there had been an un- 
usual amount of research and developmental work done in industry dur- 
ing the war. Two competitive developments were of especial concern to 
the management. One company which had not previously manufactured 
textile equipment had designed a machine which for many applications 
was apparently superior to the comparable Longs treet model. A second 
concern had secured a license from a foreign company permitting the 
manufacture of a greatly improved machine which would compete with 
another model. The two types of machinery, the sales of which were 
threatened by these new developments, normally constituted about a 
fourth of the company's dollar volume. The Longstreet Machine Com- 
pany's management was currently devoting a large portion of its time 
and energy to developmental work, with especial attention to the two 
aforementioned models. 

In addition to its engineering and marketing problems, the Long- 
street Machine Company emerged from the war with a financial prob- 
lem. Earnings had declined during wartime because of unprofitable mili- 
tary contracts and increased income tax rates, as shown in Exhibit 1 
(p. 126). At the same time, larger than normal amounts were spent 
for replacing old machinery and equipment, as shown in Exhibit 3. 
Funds had been drained as a consequence, so that the company's cash 
balance on December 15, 1945, was $154,000, despite $300,000 raised 
in October on a 1^%, 180-day note. (See Exhibit 2.) 

It had been apparent to the management throughout the autumn of 
1945 that it would have to borrow to meet the $300,000 final payment, 
due March 31, 1946, on its five-year term loan. It was also apparent that 
additional funds would be needed to finance developmental research and 
working capital requirements until sufficient cash had accumulated from 
postwar earnings. At Mr. Longstreet's request, John Bragg, the com- 
pany's treasurer, had compiled the following estimate of additional cash 
requirements for the coming year: 



122 Case Problems in Finance 

Amount 

Expenditure Minimum Maximum 

Developmental expense $ 45,000 $ 135,000 

Machinery, tools, fixtures, etc 100,000 235,000 

Plant construction 45,000 175,000 

Working capital 85,000 350,000 

Term loan installment 300,000 300,000 

90-day note 300,000 300,000 

$875,000 $1,495,000 

On November 19, 1945, Mr. Longstreet and Mr. Bragg discussed 
their financial needs with James Sheridan, an officer of the Pine Street 
National Bank. After studying the company's condition, Mr. Sheridan 
suggested a 3%, 10-year term loan in an amount up to $1,200,000. 
Participation in the loan would be offered to the company's other banks. 
The terms, as proposed by Mr. Sheridan, included the following cove- 
nants among others : 

a) The loan would be repayable in 40 equal quarterly installments; 

b) Net current assets of at least $1,500,000 would be maintained; 

c) A current ratio of at least 2:1 would be maintained; 

d) Annual and monthly balance sheets, profit and loss statements, and sur- 
plus reconciliations would be furnished; 

e) Additional indebtedness with a maturity of more than 12 months would 
be limited to a maximum of $250,000; 

/) Dividends (other than in stock) would not be paid nor would any of 
the company's stock be purchased if such payment or purchase would reduce 
surplus below the amount at the time of the signing of the loan agreement p.'us 
one-third of subsequent income otherwise available to the common stock- 
holders; ^ 

g ) Accounts receivable would not be sold or property be encumbered except 
that foreign drafts receivable could be discounted up to an aggregate of 
$125,000; 

b) Assets in excess of $50,000 would not be sold in any one year, except 
in the ordinary course of business, unless the amount in excess of $50,000 were 
applied to payment of the loan in inverse order of maturity; 

/) Expenditures on real estate, machinery, or equipment would be limited 
to $275,000 plus retained earnings and depreciation accumulated subsequent to 
the signing of the loaning agreement. The figure of $275,000 might also be 
increased by the proceeds of subsequent sales of the company's common stock; 

j) In the event of default in payment of principal or interest, or default in 
any covenant or warranty, or in certain other events, such as a general assignment 
for the benefit of creditors, or the filing of certain petitions or answers under 



^ The company had paid dividends on common stock, but very irregularly. Two dollars 
per share had been paid July 1, 1945, the first payment since 1942. 



LONGSTREET MACHINE COMPANY 123 

bankruptcy or reorganization laws, the lender would be able to declare the prin- 
cipal and interest of the entire loan immediately due and payable. 

The day after Mr. Sheridan presented his proposal, Mr. Longstreet 
received a visit from Roger Burnside, a member of the New York invest- 
ment banking firm of Sherman Brothers. Mr. Burnside explained that 
he was in Springfield in connection with his company's purchase for re- 
sale to the public of a block of common stock of another Springfield 
concern. He stated that his firm was on the lookout for additional busi- 
ness and expressed the hope that Mr. Longstreet would contact him if 
the Longstreet Machine Company should decide to raise funds through 
the sale of additional securities. 

The brief discussion of a public issue of securities stirred Mr. Long- 
street's imagination. He had had frequent occasion to reflect, since 1931, 
on the disadvantages of continual bank borrowing. Accordingly, a few 
days after the interview, a letter was sent to Mr. Burnside, and a meeting 
arranged for the following week. 

At the outset of the conference, Mr. Longstreet expressed a prefer- 
ence, if securities were sold, for an issue of about 1 1,250,000 of 5% 
preferred stock. He explained that one reason for his preference was 
that preferred stock would be nonvoting and that he was desirous of 
keeping working control of the company in hands of the Longstreet 
family. On the other hand, he appreciated the fact that working control 
probably could be maintained with less than a majority of voting power. 
Mr. Burnside replied that a new issue could be marketed by the under- 
writers over a wide geographical area and in relatively small lots so as to 
minimize the possibility of groups, unfriendly to the Longstreet's, accu- 
mulating enough stock to challenge their management. 

Mr. Burnside did not believe that the Longstreet Machine Company 
was financially strong or stable enough to make its preferred attractive 
to prospective investors unless it were to be convertible into common 
stock at the option of the holder. After some discussion Mr. Longstreet 
decided that he would prefer to issue common stock. In the event that 
preferred were issued and the preferred stockholders converted, as he 
thought that they would in view of prospective earnings for the next few 
years, the common stockholders' equity would be diluted about as much 
as if common stock had been issued in the first place. On the other hand, 
if anything happened to affect the company's prospects adversely and to 
discourage conversion, management would find itself faced with fixed 
dividend requirements at the very time it would want to conserve funds. 



124 Case Problems in Finance 

Accordingly, it was agreed to proceed on the basis of a common 
stock issue of $1,250,000. Mr. Burnside then left for New York to work 
out a preliminary proposal and to discuss the matter with his partners. 

The proposal with which Mr. Burnside returned may be outlined as 
follows : 

1. 105,000 shares of common stock would be issued at a tentative selling 
price to the public of $12 a share, after a 10 for 1 split of currently outstanding 
stock. 

2. Underwriting fees would be 9% of the selling price. 

3. Underwriter's legal expenses of approximately $6,000 would be borne 
by the company. 

4. Five-year warrants for the purchase of 7,500 shares of new common 
stock at a price of $ 1 5 a share would be authorized and sold to Sherman Brothers 
for a total of $400. These warrants would, in effect, be options to buy Longstreet 
stock from the company at any time over the five-year period at $ 1 5 regardless of 
the current market value of the stock. 

Presumably the options would be exercised only at a time when the current 
market value was more than $15, and the difference between ,cost to Sherman 
Brothers and the market value could be regarded as additional, but contingent, 
compensation to the underwriter. 

5. The final selling price would be set within 72 hours before the registration 
of the issue with the Securities and Exchange Commission would become effec- 
tive and would be filed as an amendment to the registration statement. At the 
time the selling price was set, a purchase agreement would be signed by the 
company and Sherman Brothers. This agreement would provide that the under- 
writer could cancel his rights and obligations under the agreement at any time 
up to and including the "closing date" ( i.e., date of delivery of the stock to Sher- 
man Brothers and payment therefor to the Longstreet Machine Company) if in 
the judgment of Sherman Brothers political, financial, market, international, eco- 
nomic, or other general conditions changed so as to make the public offering of 
the stock impracticable or inadvisable. The "closing date" would be set at from 
three to four days after the effective date of the registration. 

6. The stock would not be listed on an organized exchange, but the issue 
would be distributed widely. Wide distribution, it was believed, would result in 
frequent trading in the "over-the-counter" market. 

7. Mr. Burnside would be elected to the board of directors at the next annual 
meeting. 

The selling price proposed by Mr. Burnside was less than Mr. Long- 
street had anticipated. The latter had counted on receiving a price about 
equal to the stock's book value. Mr. Burnside stated, however, that sell- 
ing price was determined more by earnings than by book value. The $ 1 2 
a share price was equivalent to slightly less than 10 times average earn- 
ings, on the stock currently outstanding, for the preceding 10 years. Mr. 



LONGSTREET MACHINE COMPANY 125 

Burnside had brought a schedule which showed that the common stock 
of other textile machinery companies was selling at about 1 1 times their 
earnings for the same period. In view of the fact that the company's 
stock was closely held and was unknown to the investing public, and 
since its past financial history was not so good as that of most of the other 
companies included in Mr. Burnside's schedule, he felt that 10 times 
earnings was a fair price. Moreover, the number of common shares out- 
standing would be almost doubled, and earnings would have to be in- 
creased proportionately to make the investment attractive. 

Mr. Longstreet considered Mr. Burnside's analysis unfair because 
earnings in the preceding 10 years had been reduced by the recession of 
1938 and by losses on war contraas. The real prewar earning power of 
the company, he maintained, was over $400,000 a year, after deprecia- 
tion but before taxes. Moreover, Mr. Longstreet estimated that postwar 
earnings would be greater by at least an additional 25% because of 
manufacturing economies resulting from wartime improvements in 
plant and machinery and because of an anticipated abnormally large 
postwar demand. Thus, he felt that the company could look forward to 
earnings before taxes of at least $500,000. 

Mr. Burnside replied that he agreed with Mr. Longstreet's analysis 
of the company's prospects but that the Securities Act of 1933 prevented 
his firm from using predictions and estimates as "bait" in selling secu- 
rities to the public. The information that could be included in the pros- 
pectus was, in effect, limited to fact because the underwriter and the 
company's officers were liable for the statements contained therein. 
Moreover, Mr. Burnside stated that his firm liked to be associated with 
"successful issues." A "successful issue" was one which went up a point 
or two after its public offering. A "successful issue" was of benefit to the 
issuer as well as to the underwriter, he maintained, because it made the 
public more receptive to future issues of the same company. 

Mr. Longstreet was unable to obtain any concessions from Mr. 
Burnside. During the following two weeks he sounded out several other 
underwriters, none of whom made offers which he considered more fa- 
vorable than the one received from Sherman Brothers. 

After discussing the matter with other company officers and with 
his lawyers, Mr. Longstreet called a meeting of the directors for Decem- 
ber 17, 1945, for the purpose of considering means of raising funds. In 
his discussion with his lawyers, Mr. Longstreet had learned that getting 
out the proposed stock issue would take the following length of time: 



126 



Case Problems in Finance 



five to six weeks to prepare the registration statement required under the 
Securities Act of 1933; about three weeks to receive a possible "defi- 
ciency letter" from the Securities and Exchange Commission outlining 
any revisions they would require; from one to two weeks to negotiate 
and file the amendments requested in the deficiency letter; and two to 
four days to "close" with the underwriter. 

In further preparation for the board meeting Mr. Longstreet made 
some brief calculations which he planned to lay before the board. He 
first calculated the effect each plan, if adopted, would have on the earn- 
ings per common share outstanding. The effect was calculated first on 
the assumption of net earnings before taxes and interest of $500,000. 
In view of Mr. Burnside's more conservative view of future earnings he 
also figured out the effect of each of the proposed plans on earnings per 
share if earnings were about equal to the average of the last 10 years. 
Mr. Longstreet's calculations are shown in part in Chart 1 and Exhibit 4. 

Exhibit 1 
LONGSTREET MACHINE COMPANY 
Summary of Earnings 
(Dollar figures in thousands) 
Fiscal 
Year 
Ending 
Sept. 30 
1936 
1937 
1938 
1939 
1940 
1941 
1942 
1943 
1944 
1945 

Average 

* Before depreciation, interest, and income taxes, 
d Deficit 



Net 




Depre- 




Income 


Net 


Sales 


Income* 


ciation 


Interest 


Taxes 


Income 


$2,861 


$515 


$ 99 


$12 


$ 68 


$336 


3,473 


509 


100 


8 


115 


286 


2,920 


329 


100 


4 


53 


172 


2,430 


55 


96 


5 


10 


56*^ 


3,301 


389 


97 


8 


87 


197 


3,341 


433 


110 


14 


81 


228 


3,972 


478 


164 


26 


100 


188 


2,963 


190 


147 


26 


18 


r 


2,954 


398 


147 


21 


86 


144 


3,217 


309 


148 


11 


60 


90 




361 


121 


. . . 


68 


158 



LONGSTREET MACHINE COMPANY 

Exhibit 2 

LONGSTREET MACHINE COMPANY 

Balance Sheets 

(Dollar figures in thousands) 

Sept. 30 
1943* 
ASSETS 
Current assets: 

Cash $ 189 

Accounts receivable 300 

Inventories : 

Raw material 236 

Parts in process 501 

Finished parts 749 

Machines in process 268 

Total inventory $1,754 

Other current assets 8 

Total current assets $2,25 1 

Fixed assets: 

Land, building, machinery, etc $2,999 

Less allowance for depreciation 1,583 

Total fixed assets $1,416 

Other assets 49 

Total assets $3,715 



127 



Dec. 13 
1943 



$ 154 
443 



l,962t 

3_ 

$2,562 



$3,059 
1,641 




LIABILITIES AND CAPITAL 
Liabilities : 

Notes payable to banks: 

Due March 31, 1946 $ 325 $ 300 

Due April 6, 1946 300 

Accounts payable — trade 199 212 

Customers' advances on contracts 32 40 

Accrued liabilities 50 51 

Provision for taxes 162 167 

Total current liabilities $ 768 $1,070 

Capital: 

Common (no par, stated value $100) $1,276 $1,276 

Surplus 1,671 1,690 

Total capital $2,947 $2,966 

Total liabilities and capital $3,715 $4,036 

• Audited. 

t The company's cost accounting system did not provide a breakdown of inventory, which was obtainable 

only by means of a physical count. 



128 



Case Problems in Finance 





Exhibit 5 






LONGSTREET MACHINE COMPANY 




Expenditures for Machinery and Equipment and 




FOR Development and Research 






(Dollar figures in thousands) 






For Machinery and 


For Development and 


Fiscal Year 


Equipment {Charged 


Research {Charged 


Ending Sept. 30 


to Capital Accounts) 


to Expense) 


1936 


$ 89 


% 79 


1937 


97 


110 


1938 


84 


167 


1939 


105 


182 


1940 


124 


190 


1941 


443 


219 


1942 


245 


263 


1943 


117 


196 


1944 


95 


137 


1945 


170 


155 



Chart 1 



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LONGSTREET MACHINE COMPANY 

ALTERNATE PLANS IN AVERAGE YEAR- EFFECT ON EARNINGS PER 

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LONGSTREET MACHINE COMPANY 

Exhibit 4 

LONGSTREET MACHINE COMPANY 

Effect of Alternate Plans on Earnings 

PER Share of Common Stock* 

At Assumed Earnings Level of $500,000 before Interest and Taxes 

Term Common 

Loan Stock 

Assumed income before interest and taxes $500,000 $500,000 

Less: Interest at 3% on average loan outstanding 18,000 

$482,000 $500,000 

Less: Taxes at 38% 183,160 190,000 

Net income after taxes $298,840 $310,000 

Number of shares of stock 12,760 23,260^ 

Net income per share of present common stock. .$ 23.40 $ 13.30 

At Assumed Earnings Level of $240,000 before Interest and Taxes 

-''----_ Term Common 

Loan Stock 

Income before interest and taxes $240,000 $240,000 

Less: Interest at 3% on average 18,000 

Net income before taxes $222,000 $240,000 

Less: Taxes at 38% 84,360 91,200 

Net income after taxes $137,640 $148,800 

Number of shares of stock 12,760 23,260^ 

Net income per share of common stock $ 10.80 $ 6.40 

* To provide comparability, this number is expressed in "old" shares. 



129 



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Dixley Paper Company (A\ 



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On February 5, 1946, the executive committee of the Dixley Paper 
Company was considering, as alternative methods of raising capital, the 
issuance of debentures and of preferred stock. 

The Dixley Paper Company manufactured paper for industrial and 
commercial use. Sales were made direct, and through jobbers, to con- 
verters and industrial concerns. The company's papers were used in the 
manufacture of a wide variety of items. Management took great pride in 
the quality of its products, which enjoyed a high reputation in the trade. 
Over one-third of its customers had been doing business with the com- 
pany for 25 years or more. 

The paper industry was highly competitive. Over 450 concerns man- 
ufactured pulp, paper, and paper board in the United States in 1945, 
while substantial quantities of pulp and paper were imported from Can- 
ada and the Scandinavian countries. Total over-all capacity exceeded de- 
mand, as evidenced by the fact that the paper industry operated at about 
two- thirds of nominal capacity in the 20-year period ending with 1940. 
The industry was not dominated by any one company or group of com- 
panies. Notwithstanding competitive conditions, the Dixley Paper Com- 
pany had a long record of profitability. (See Exhibit 1.) Common stock 
dividends had been declared every year for a half-century, and during 
the preceding decade annual payments had ranged from $2.00 to $3.00 
a share. Since 1942 annual payments had been $2.50 per share. 

The company's stock had been closely held prior to the death in 
1939 of Amory Williams, a major shareholder. In the settlement of his 
estate, a large block of the Dixley Paper Company stock was sold to an 
investment banking firm which resold it to investors at a favorable price. 
The company was in no way connected with this transaction. 

As was typical of the industry, sales declined more than 25 % during 

130 



DixLEY Paper Company (A) 131 

the depression of the early 1930's. Inventories and receivables were re- 
duced more than proportionately, resulting in substantial accumulations 
of cash. This excess cash was invested in government securities and was 
also used to purchase such shares of company stock as became available 
at the depressed prices typical of the period. In 1936 management de- 
cided to use its ''idle" funds to build a $7,000,000 mill in the South, at 
which it was planned to produce high strength sulphate Kraft paper to 
supplement the line of fine sulphite papers produced at the company's 
New England mills. 

Construction of the southern mill was a lengthy process. Production 
of pulp was not commenced until late 1940 and paper wa,s not pro- 
duced until early 1941. Demand for paper products increased while the 
plant was under construction, necessitating additional investment in in- 
ventory and receivables, which was financed through bank loans. Late in 
1940 a $3,000,000 3i% five-year term loan was arranged, the proceeds 
of which were used to liquidate debt incurred during the building of the 
plant and for working capital. 

George Holmes, the company's treasurer, observed during the fol- 
lowing year that companies with equivalent credit standing were obtain- 
ing bank loans on more favorable terms. Making a study of industrial 
borrowing, Mr. Holmes concluded that 2|% was the current going rate 
for comparable loans. He sounded out several bankers and confirmed 
that they would be willing to lend the company sufficient money at 2| % 
to refund the amount outstanding on the 3i% loan. Part of the success 
of the Dixley Paper Company was attributable to management's skillful 
bargaining with sellers of pulpwood and pulp. In its opinion, the hiring 
of money was essentially like the purchase of a commodity, and bankers 
were only human and could be bargained with just like other business- 
men. Accordingly, a meeting was arranged with representatives of the 
bank at which it was pointed out that 3^% was too high an interest rate 
and that money was available at 2|% for the purpose of refunding the 
loan. After some discussion, the bank consented to reduce its rate to the 
2|% figure. 

Throughout World War II a critical shortage of pulpwood, pulp, 
and paper was experienced by the United States. This shortage was at- 
tributable to an unprecedented demand for pulp and paper products and 
to interruption of imports from Scandinavia. To meet this situation, the 
government established severe restrictions on the amount of inventory 
a concern could carry. In order to keep within War Production Board 



132 Case Problems in Finance 

allocations, the Dixley Paper Company was forced to sell substantial 
quantities of pulp. It also became necessary to reduce harvesting opera- 
tions in company-owned woodlands because of a shortage of woods la- 
borers. Reduction of inventories attributable to these influences pro- 
vided sufficient cash to repay the $3,000,000 term loan as it matured. 
This debt was completely paid early in 1945. 

Lifting of government controls after the cessation of hostilities cre- 
ated a severe drain on cash. The ending of priorities and the ensuing 
scramble for pulpwood and pulp forced management to increase inven- 
tories to levels which would insure uninterrupted production under the 
new conditions. Because of increased sales attributable to the southern 
mill, which had nearly doubled the company's capacity, and the unprece- 
dentedly great postwar demand for paper, management was faced with 
the necessity for carrying larger unit inventories than ever before in its 
history, while costs were 100% above prewar levels. In addition, sub- 
stantial expenditures were required for repair and purchase of machinery, 
much of which was in poor condition because of wartime shortages of 
parts and replacements. This combination of factors created a need for 
more working capital than the company possessed. To meet the need, 
$2,150,000 had been borrowed from banks on 90-day 1^% notes by 
November, 1945, and an additional $550,000 in January, 1946. 

Notwithstanding these borrowings, management foresaw need for 
additional cash. Expenditures for machinery and equipment during the 
next few years were expected to total close to $2,400,000. About 
$600,000 had been allocated for purchase of woodlands in the vicinity 
of the southern mill. Inventories, it was expected, might increase by as 
much as another two or three million, depending upon volume of sales, 
wage levels, availability of woods laborers, and the price and supply of 
purchased pulpwood and pulp. 

Abundant bank credit was available, but management did not be- 
lieve that it was sound financial policy to be continually in debt to banks. 
Management wished to borrow only during the winter and spring, when 
pulpwood inventories were at a peak, and to "clean up" its bank loans 
by late summer of each year. Harvesting and peeling of pulpwood 
started in the north in the early fall, at which time inventory was at its 
annual low and continued until the spring thaw, when a 12 months' 
supply of peeled logs was floated down the river to the company's pulp 
mill. 



DiXLEY Paper Company (A) 133 

George Holmes, who kept in close touch with the securities market, 
had noted during the latter part of 1945 that many concerns were taking 
advantage of favorable market conditions to sell securities publicly. Mr. 
Holmes was confident that the company would be able to raise perma- 
nent capital on favorable terms under current market conditions because 
of its long record of profitability and financial strength. These views he 
introduced at a meeting of the executive committee late in January. The 
idea of a public issue was well received by the other officers. Opinion 
was divided as between preferred stock and debentures, with common 
stock being ruled out because it was known that the principal stock- 
holders would oppose any substantial dilution of their equity. Accord- 
ingly, Mr. Holmes was asked to prepare a comparison of the terms that 
could be expected for a debenture issue and for preferred stock. 

On February 5, 1946, Mr. Holmes presented alternative proposals 
for consideration. In preparing the plans he had given careful considera- 
tion to the terms on which other paper companies had issued securities 
in recent weeks and to the company's bargaining position. 

Mr. Holmes conceded that prospective underwriters would vigor- 
ously object to the terms of underwriting compensation and selling 
prices he had outlined, but he was confident that his terms would finally 
be accepted. There was a good market for high-grade industrial deben- 
tures and preferred stock. The proposed issue would have no senior secu- 
rities ahead of it, and interest or dividend requirements would be small 
relative to past earnings and to the dividends that had been paid, without 
fail, for 50 years. Moreover, the company's stock was quoted frequently 
on the over-the-counter market and had been known to New England 
investors since the sale of Amory Williams' block of shares in 1939. 
Distribution of the proposed issue would, Mr. Holmes stated, be an easy 
matter, with every likelihood that it would be oversubscribed. Mr. 
Holmes's plan was to negotiate with a number of underwriting firms si- 
multaneously and to hold out until his terms were accepted by one or 
another. 

Mr. Holmes's proposed terms for a $5,000,000 debenture issue may 
be outlined as follows: 

1. Annual interest at the rate of 3% of face value. 

2. Selling price to the public of about 103. 

3. An underwriting fee of 1^% of selling price. 

4. Sinking fund provisions calling for retirement of the issue over a 15 -year 



134 Case Problems in Finance 

period with equal sinking fund payments each year. Debentures would 
be subject to call by lot for sinking fund redemption at the following 
prices: 

1947 104 1955 lOli 

1949 103 1958 100^ 

1952 102 1961 100 

5. Provisions providing for redemption (other than for the sinking fund) 
of the issue in whole, or in part by lot, at the following prices: 

1946 105 1955 lOH 

1949 103i 1958 lOOf 

1952 102i 1961 100 

6. Provisions prohibiting the company from creating, assuming, or guar- 
anteeing mortgage indebtedness, except purchase money mortgages, un- 
less the debentures were secured by such mortgage equally and ratably 
with all other indebtedness so secured. 

7. Provisions prohibiting the creation, assumption, or guaranteeing of 
funded debt unless net tangible assets were at least 250% of the sum 
of funded debt to be outstanding and net income for the two most recent 
fiscal years shall have averaged 250% of the sum of annual interest 
charges on funded debt to be outstanding. 

8. Limitation of the right to pay cash dividends if such payments would 
reduce surplus below the amount at the time of issue or reduce current 
assets below 200% of current liabilities, or if interest or sinking fund 
payments on the debentures were in arrears. 

9. In the event of default (after 30 days' grace period on interest and 60 
days' grace period on sinking fund payments), the trustee, or holders 
of not less than 25% of the debentures outstanding, could declare the 
principal of all debentures to be due and payable immediately. 

10. Modification and alteration of the indenture could be made with the 

consent of the company and holders of two-thirds of the debentures, 

subject to the following exceptions: 

a) No changes could be made in terms of payment of principal at 
maturity or of interest or premium. 

h) No limitation could be made of the right of any debenture holder 
to institute suit for the enforcement of any such payment after its 
due date. 

c) No reduction could be made in the proportion of debentures re- 
quired to modify or alter the indenture. 

Mr. Holmes' proposed terms for a $5,000,000 preferred stock issue 
were as follows (see page 138) : 



DixLEY Paper Company (A) 



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138 Case Problems in Finance 

1. Cumulative annual dividends of $4.00 a share on shares of par value of 
100. 

2. Selling price to the public of about 105. 

3. An underwriting fee of $2.00 a share. 

4. Provisions providing for redemption of the issue in v^hole, or in part 
by lot, at the following prices: 

1946 109 1955 107i 

1951 108i 1957 107 

1953 108 1959 106^ 

1961 and thereafter. .106 

5. Provisions providing for a retirement fund, starting in 1950, whereby 
2Vi% of the original issue would be redeemed annually. Shares would 
be subject to call by lot for retirement fund redemption at the following 
prices: 

1950 107 1955 105i 

1953 106i 1956 and thereafter . . 105 

1954 106 

As an alternative, the company would be allowed to surrender for credit 
to the retirement fund, at the current redemption price, shares purchased 
and then held as treasury stock. 

6. Upon the liquidation or dissolution of the company, holders of the pre- 
ferred stock would be entitled to receive $100 a share plus accrued and 
unpaid dividends if the liquidation were involuntary or the redemption 
price then in effect (applicable to redemption other than through the 
retirement fund ) if the liquidation or dissolution were voluntary, before 
any payment or distribution would be made on the common stock or on 
any other class of stock junior to the preferred stock. 

7. The company would not, without an affirmative vote of at least two- 
thirds of the preferred stock, do any of the following: 

a) Authorize stock ranking prior to or on a parity with the proposed 
issue. 

b) Incur funded debt unless: net tangible assets were not less than 
250% of the sum of funded debt to be outstanding plus the in- 
voluntary liquidating value of the preferred stock; net income for 
three out of the four most recent fiscal years shall have averaged 
250% of the sum of annual interest charges on funded debt to be 
outstanding plus annual dividend requirements on preferred stock. 

c) Pay dividends on stock junior to the preferred if such payments 
would reduce surplus below the amount at the time of the issue or if 
preferred stock dividend or retirement fund payments were in 
arrears. 

8. In the event that preferred stock dividends or retirement fund payments 
were in arrears in an aggregate amount equal to one year's requirements, 
the holders of the preferred stock would have the right, voting separately 
as a class, to elect one-third of the total number of directors. 



^\VVVVVVVVVVVVVVVVVVVVVVVVVVVVWV\V\AAA\V\AA\VVVVVVA^^ 



Vickery Department Store 



(VVVVWVVVVA\\VVVVVVVV\VVVVVVVVVVVVVVVVWVVVVWVVV\VVWVWVVVWW 



Following the end of the war in 1945, the management of the Vick- 
ery Department Store developed plans for modernization of its two exist- 
ing store buildings, for expanded warehouse facilities, and for a new 
store building in a growing part of its city. These plans would require 
large amounts of funds over a period of years. But by the middle of 
1946, it became clear that the rapid increase of sales would require about 
$2,000,000 for working capital before the program of expansion could 
be perfected. Alternate sources for this immediate requirement appeared 
to be a bank term loan or a "sale and lease-back" of company property. 

Exhibit 1 shows the most recent balance sheet; Exhibit 2 shows a 
summary of operating results for the past 10 years. 

In June, 1946, the company had arranged with a large New York 
bank a term loan commitment whereby the company could borrow 
$2,200,000 at 2i% per annum on or before July 15, 1947. If the loan 
were "taken up" in full, principal was to be repaid in annual amounts of 
$220,000 from 1948 to 1955, inclusive, with a final payment of 
$440,000 in 1956. A stand-by commission of i of 1% of the possible 
loan was to be charged on the full amount of this commitment until it 
was borrowed. 

The loan agreement required the company to maintain at all times 
a net working capital of at least $3,500,000 and to obtain the bank's 
consent in order to: 

1. Mortgage or pledge any property for loans in excess of $3,000,000; an 
exception to this requirement was "purchase money obligations" not exceeding 
662/^% of cost of property acquired after December 31, 1945; 

2. Create any funded debt unless afterwards the tangible assets less cur- 
rent liabilities were not less than 1662^% of the sum of the funded debt and the 
par value of the outstanding preferred stock; 

3. Pay any dividends, except in stock, after January 31, 1945, except to 
extent of net earnings subsequent to January 31, 1945, plus $300,000. 

139 



140 Case Problems in Finance 

"Sale and lease-back" arrangements were growing in frequency; and 
Mr. Kingdon, treasurer of Vickery, learned the general outlines of such 
financing through his acquaintance with an officer of another company 
which had recently entered such an agreement. This particular company 
had received $6,750,000 for the sale of its real estate (land and build- 
ings) to an insurance company. Simultaneously, the company had 
agreed to lease the property it had sold for a period of 22 years under 
the following schedule of rental payments: 

For each lease year ( February 1 to January 3 1 ) of the first five 

years $515,000 

For each of the next five lease years 460,000 

For each of the next five lease years 415,000 

For each of the next five lease years 365,000 

For the next lease year 300,000 

For the final lease year, ending January 31, 1968 295 ,000 

This schedule permitted the lessor to earn 3^% on the investment, 
while writing \t off over the 22 years. 

The principal provisions of the lease to which Mr. Kingdon's ac- 
quaintance was a party were as follows : 

1. Lessee shall pay as additional rent all real estate taxes, assessments, water 
rates, etc. 

2. Lessee shall keep all buildings insured to at least 80% of their full insur- 
able value and will indemnify the lessor from any liability or expenses for injury 
to person or property of any nature. 

3. Lessee shall keep all buildings in good repair at the sole cost of the lessee, 
reasonable wear and tear excepted. 

4. Trade fixtures, furniture, and equipment now installed shall not become 
part of premises, but all alterations and building equipment shall become part of 
premises and shall remain at the termination of the lease. 

5. In the event that the property is condemned the lease shall end and the 
award shall be apportioned between the lessor and lessee upon a predetermined 
formula. 

6. The lessee shall have the right at any time to make such alterations, 
changes, and new constructions as the lessee shall deem desirable to suit the 
lessee's convenience, provided that, if the estimated cost of such alteration is in 
excess of $100,000, the buildings after the completion of such project shall be of 
a value that is not less than that prior to the alterations. 

7. If at any time the lessee shall desire to demolish 50% or more of the floor 
space for the purpose of erecting a new building, the lessee shall not commence 
demolition until the plans of the new building have been approved by the lessor; 
and the lessor covenants that it will not unreasonably withhold its approval of 
such plans. 

8. The lessee shall have the right, at its option, to extend the lease for three 



ViCKERY Department Store 14 1 

separate renewal terms of 22 years each. The conditions and agreements of the 
original term shall pertain, except that the rent for each renewal term shall be at 
the rate of $75,000 per annum. The lessee shall not have the right to extend the 
lease for any term beyond January 31, 2034. 

Working on the assumption that the entire properties of the ware- 
house and the Main Avenue store could be sold at book value, Mr. 
Kingdon determined that a lease similar to the one which he had re- 
viewed would call for rental payments approximately equal to the fol- 
lowing schedule: 

For each lease year for the first five years, annual rent of $158,620 

For each lease year for the next five years, annual rent of 141,680 

For each lease year for the next five years, annual rent of 127,820 

For each lease year for the next five years, annual rent of 112,420 

For the next lease year, annual rent of 92,400 

For the last lease year, annual rent of 90,860 

In studying the provisions of such a lease Mr. Kingdon noted that 
ail of the expenses currently incurred by the company in carrying the 
several properties would be included either in the rental payments to the 
lessor or in the miscellaneous charges which the lessee would agree to 
carry. In his own thinking, however, Mr. Kingdon was accustomed to 
regard the alternative earning power of money invested in property as a 
hidden cost of carrying the investment in the property. In other words, 
if the funds were not "tied up" in the particular property, he felt that 
they could have been invested in good stocks or bonds and an income of 
about 4 % obtained on the investment. By entering into a sale and lease- 
back arrangement, the company would, in effect, free the funds cur- 
rently invested in property for other uses. However, included in the 
rental fees would be the interest, presumably 3^%, the lessor expected 
to earn on its investment in the properties. Exhibit 3 summarizes Mr. 
Kingdon's calculations of the hidden cost of the current investment by 
Vickery in the several properties. ^ 7^ ^ y ^ t> 

In studying the informatiparinExhibit 3, Mr. Kingdon realized that 
the value of land ($571,9D5) would be written off over the 22-year 
period through the rental charges. Since the cost of the land could not 
ordinarily be recovered through depreciation charges, inclusion of land 
amortization charges in the rental payments would effect a tax savings 
under current rates of about $10,000 yearly. 

Mr. Kingdon wondered about the possibility of repurchasing the 
property at the end of any proposed lease. Although the lease he had 
examined did not include any such provision, he was aware that repur- 
chase options were permissible. 



142 Case Problems in Finance 

Exhibit 1 

VICKERY DEPARTMENT STORE 

Balance Sheet as of January 31, 1946 

(Dollar figures in thousands) 

CURRENT ASSETS 

Cash and U.S. obligations $ 2,264 

Receivables (less reserve $150) 1,649 

Merchandise 3,162 

Tofal current assets $ 7,075 

Land 797 

Buildings, improvements, furniture and fixtures $4,628 

Less: Reserve for depreciation 2,634 1,994 

Nonoperating properties 290 

Miscellaneous assets 670 

Total assets $10,826 

CURRENT LIABILITIES 

Accounts payable $ 1,325 

Provision for federal and state income taxes (less U.S. tax 

notes $600,000) 1,023 

Accrued miscellaneous liabilities 602 

Total current liabilities $ 2,950 

Reserves for self-insurance 30 

4i% cumulative preferred, $100 par — authorized and issued, 

26,400 shares 2,640 

Common, no par, authorized 47,500 shares, outstanding 

42,996 shares % 260 

Less: Treasury stock 4,504 shares 157 103 

Earned surplus 5,103 

Total liabilities $10,826 



ViCKERY Department Store 



143 



Exhibit 2 
VICKERY department STORE 
Summary of Operating Results 





(Dollar figures in 


thousands ) 




Years Ended 


Profits before 


Income Net 


Dividend 


Jan. 31 Net Sales 


Income Taxes 


Taxes Profits 


Paid 


1937 $10,392 


1 503 


% 155 $348 


$162 


1938 11,112 


AAG 


133 313 


162 


1939 10,165 


297 


73 224 


130 


1940 10,405 


391 


103 288 


219 


1941 10,859 


533 


157 376 


259 


1942 13,458 


905 


485 420 


268 


1943 15,205 


1,315 


866 449 


259 


1944 17,453 


1,670 


1,182 488 


259 


1945 20,139 


2,252 


1,686 566 


258 


1946 23,236 


2,542 


1,837 705 


264 




Exhibit 3 




VICKERY DEPARTMENT STORE 




Depreciated Value of 


Property (Excluding Automobiles) as of Jan 


. 31, 1946 








Earning Power 








at 4% of Funds 








Now Invested 








in Property 


Main Avenue: 








Land 





$ 552,740 


$ 22,110 


Buildings 





806,181 


32,248 


Equipment 




423,946 


16,957 


Total branch 


property 


$1,782,867 


$ 71,315 


Seventh Street: 








Land 





$ 225,220 


$ 9,009 


Buildings 




341,905 


13,676 


Equipment .... 




141,994 


5,679 


Total branch 


property 


$ 709,119 


$ 28,364 


Warehouse: 








Land 




$ 19,165 


$ 766 


Buildings 




252,437 


10,097 


Equipment 




23,361 


935 


Total warehouse property 


$ 294,963 


$ 11,798 



Total all property $2,786,949 



$111,477 



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Consolidated Motive Company 



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In July, 1946, the directors of the ConsoHdated Motive Company 
decided to refund its $7.00 cumulative preferred stock. The $7.00 pre- 
ferred stock, of which there were 100,000 shares outstanding, was call- 
able at $1 15 a share, making a total of $1 1,500,000 required for calling 
the entire issue. 

The directors had considered various alternative methods of financ- 
ing the proposed refunding and eliminated all but the following: 

1. The issue of $11,500,000 par value 4% sinking fund 15-year debentures. 
It was thought that such an issue of debentures could be sold at a price to the 
public of 104. Underwriter's fees and other expenses of issue were expected to 
total about 4% of par so that the company would net the face value of the pro- 
posed issue. Proposed sinking fund provisions called for retirement of 3i% of 
the par value of the issue each year. Bonds could be called by lot at the price of 
105 for this purpose. Thus, bonds with face value of $383,334 would be retired 
each year, leaving a total of $5,750,000 outstanding at maturity date. 

2. The issue of 115,000 shares of $5.00 cumulative preferred stock. It was 
thought that this issue could be sold to the public at $105 a share. Underwriter's 
fees and other expenses of issue were expected to total $5.00 a share. It was pro- 
posed that the new issue provide that in the event of nonpayment of a total of one 
year's dividends the preferred stockholders would be entitled to elect 2 of the 
company's 15 directors. A similar clause was contained in the provisions of the 
currently outstanding issue of $7.00 preferred. The new issue would be callable 
at $110 a share. Neither the current nor the proposed issue of preferred contained 
any sinking fund provisions. 

3. The sale of additional common stock to the public. (The current common 
stockholders had no pre-emptive rights to purchase additional common stock.) 

The price range of the common stock on the New York Stock Ex- 
change in recent months had been as follows: 

144 



Consolidated Motive Company 145 

High Low 

January 44^ 38i 

February 43| 35i 

March 371 34f 

April 381 35 

May 401 35i 

June 40i 36i 

Company officials had discussed the problem of financing with a 
prominent New York investment banking firm. The investment bank- 
ers felt that each of the above means of raising funds was currently fea- 
sible. Barring a change in market conditions, they expressed a willing- 
ness to act as principal underwriter for either bonds, preferred stock, or 
common stock on the basis outlined. It was the bankers' opinion that a 
new issue of common stock could be sold to the public at about 36. 
After deduction of the bankers' charges the company would receive 
about $34.50 per share. However, the company could expect additional 
expenses connected with the issue of common stock of roughly $60,000. 
Hence, to net $11,500,000 an issue of approximately 335,000 shares of 
new common stock would be required. 

There were currently 875,000 shares of common stock outstanding. 
These shares were widely distributed; no single group could be said to 
dominate the company, and the directors did not consider it likely that 
anyone would seek to gain a controlling interest. 

The Consolidated Motive Company manufactured steam and Diesel- 
electric locomotives. The great majority of the company's sales were 
made on a contract basis. Except for a relatively small stock of replace- 
ment parts, the company did not produce for inventory. As a means of 
compensating for unfavorable trends in the railroad industry, the com- 
pany in 1931 undertook the manufacture of heavy distillation equip- 
ment for the chemical and petroleum industry. 

Despite some success with the distillation equipment line, locomo- 
tives and locomotive parts still comprised the bulk of the company's 
peacetime sales; and the company's sales continued to be subject to wide 
cyclical variation. The Consolidated Motive Company was hard hit dur- 
ing the depression of the 1930's, as may be seen from a study of Ex- 
hibit 1. 

Sales and earnings increased substantially during the war and the 
prewar rearmament period. In addition to the manufacture of locomo- 
tives for the military, the company undertook the manufacture of tanks 



146 Case Problems in Finance 

and other war products on a large scale. The company's earnings during 
this period are given in Exhibit 1. 

In 1943 a recapitalization plan was adopted which eliminated the 
accumulated dividend arrearages on the preferred stock. The net effect 
of this plan was to give the preferred stockholders 1.715 shares of com- 
mon stock for each share of preferred in lieu of the $42 per share of 
accumulated dividends. The amount of common stock outstanding was 
thereby increased from 375,000 shares to a new total of 675,000. The 
number of preferred shares and the $7.00 cumulative dividend rate re- 
mained unchanged. 

In October, 1945, the company sold 200,000 shares of common 
stock to the public at a price of $36 a share. Underwriters' fees were 
$1.50 a share and other expenses connected with the issue totaled 
$60,000. The proceeds of this issue, plus $1,780,000 of excess cash, 
were used to call 75,000 shares of $7.00 preferred stock, leaving a total 
of 100,000 shares outstanding. 

The company's current cash position, as shown by Exhibit 2, was 
strong. Anticipated increases in working and fixed capital, however, 
were expected to absorb most, if not all, of the funds currently invested 
in government securities. 

Company officials regarded the immediate outlook for earnings in 
July, 1946, as highly favorable. Profits before taxes for the first half of 
1946 amounted to $2,750,000 ($1,700,000 after taxes of approxi- 
mately 38%). Two quarterly dividends of $0.35 per share had been 
declared on the common stock. The backlog of unfilled orders was equal 
to about 12 months' normal production. In addition to strong domestic 
demand for locomotives and distillation equipment attributable to favor- 
able conditions in the railroad and chemical industries, foreign demand 
for the company's products was unusually heavy. 



Consolidated Motive Company 



147 



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148 Case Problems in Finance 

Exhibit 2 

CONSOLIDATED MOTIVE COMPANY 

Balance Sheet, May 31, 1946 

(Dollar figures in thousands) 

ASSETS 

Cash 

U.S. government securities, at cost 

Accounts receivable, net 

Termination claims (U.S. government) 

Inventories : 

Raw materials $ 4,589 

Work in process 10,897 

Finished products 1,136 

Total current assets 

Investments 

Fixed assets, net 

Deferred charges 

Total assets 

LIABILITIES 

Accounts payable 

Dividends payable 

Accrued liabilities 

Advances from customers 

Reserve for income and excess profits taxes 

Total current liabilities 

Liability for purchase of government facilities 

Reserves : 

Accident indemnity 

Contingency 

Capital stock: 

Preferred, $7.00 

Common, $1.00 par 

Surplus : 

Capital 

Earned 

Total liabilities 



$ 6,582 
5,754 
6,359 
2,376 



16,622 

$37,693 

1,679 

13,183 

317 

$52,872 



$ 4,396 

482 

2,776 

5,164 

7,690 

$20,507 
395 

1,058 
3,826 

10,000 
875 

6,500 
9,711 

$52,872 



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Cellulose Corporation 



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Immediately after World War II, Cellulose Corporation embarked 
upon a long-term expansion program that was expected to require 
many millions of dollars. This expansion was financed over a period of 
time through a combination of internal sources, the use of part of the 
proceeds of a convertible preferred issue sold in April, 1946, and a 
$36,000,000 debenture issue sold in October, 1946. By the fall of 1947 
further production facilities were required and it was deemed advisable 
to raise $30,000,000 to finance part of this enlarged expansion program. 
At first, plans were made to sell $30,000,000 of 4% preferred stock. It 
became apparent, however, that this stock could only be marketed with 
dividend or sinking fund rates which the company's directors thought 
unreasonable. Consequently, a "stand-by" bank credit of $30,000,000 
was arranged and drawn down to the extent of $12,000,000 to 
take care of current payments in the construction program. In Jan- 
uary, 1948, the finance committee of the board of directors, headed by 
Mr. Bryan D. Knowles, was considering whether the financing should 
be put on a permanent basis. 

Before the Second World War the Cellulose Corporation was a 
large manufacturing concern specializing in cellulose acetate products 
for use in the textile and plastics industry. Its issues of preferred and 
common stock enjoyed a high investment standing. As the consequence 
of extensive developments in the field of organic chemistry during the 
war, the company spent $34,800,000 for new manufacturing facilities 
in the period from 1941 to 1945, inclusive. In 1945 the company an- 
nounced plans for a $55,000,000 expansion program to be spread over 
a four-year period. One year later, revised plans were made public to 
spend $60,000,000 on new facilities, half of which were scheduled for 
1946. These funds were to be obtained partly from new financing. 

Annual net profits after taxes in the years 1937-1945 were m the 

149 



150 Case Problems in Finance 

range of $6,000,000 to $8,000,000 with the exception of 1938, when 
they dropped to $3,780,000. With the removal of excess profits taxes, 
profits after taxes rose to $12,600,000 for the year 1946. Dividends had 
been paid on the common shares each year since 1924. Exhibit 1 (p. 
159) and Charts 1 and 2 (p. 160) portray the growth of the company. 
The principal executives of the company had long considered that 
this type of growing industrial company should be financed by means 
of stock rather than by debt. As of December 31, 1945, the company's 
capitalization included 252,000 shares, 4^% cumulative preferred 
stock outstanding, with a par value of $25,200,000. This stock had 
been issued at a time when 4^% was considered a very good rate. There 
were 4,564,325 common shares outstanding, with a total par value of 
$22,821,624. 

The directors decided early in 1946 that the expansion should be 
financed by preferred stock issues and in preparation for this financing 
called a special meeting of the shareholders, who authorized the direc- 
tors to issue up to 625,000 shares of preferred stock as they might 
decide. This authorization was unusual in scope. In addition to allowing 
the directors to decide upon the details of any issue, e.g., amount, rate, 
type, and series, the stockholders also voted to the directors the right 
to reissue at any time any of the preferred stock that might have been 
redeemed, or converted into common, rather than stipulating that such 
shares should be canceled. This "open-end" provision was designed to 
set up a "revolving" preferred stock authorization and to provide the 
company with a flexible financing vehicle during future expansions. 
This was an important consideration inasmuch as the institutions which 
were expected to buy large blocks of the company's preferred issues 
usually refrained from voting their shares. This often made it difi&cult 
to secure the necessary quorums and majorities to authorize new issues. 
Furthermore, it was felt that it might not be easy to persuade a preferred 
holder that it was to his advantage to place another issue pari passu to 
his stock. 

Early in April, 1946, under this authorization, the company sold 
380,360 shares, $100 par, 3^% preferred stock, convertible into com- 
mon stock on the basis of two shares of common for one share of pre- 
ferred. Under the company's charter no obligation existed to ofiFer 
common shareholders a pre-emptive right to subscribe to this issue. 
Nevertheless, the directors decided to grant to the common stock- 
holders the right to subscribe pro rata to the issue of new preferred 



Cellulose Corporation 151 

stock at a price of $101.50 and arranged a stand-by underwriting agree- 
ment with the investment house of Ludlow, Milner & Co. The manage- 
ment felt that issuing rights always pleased the stockholders and 
therefore took the opportunity to do so. The market was considered 
relatively stable at the time, so no great price declines were expected 
while the rights were outstanding. 

A small part of the shares, 1^% of the total, was not taken up by 
the exercise of warrants and was sold to the public at $122 per share by 
Ludlow, Milner & Co., who paid to the company 80% of the proceeds 
in excess of $101.50. Altogether the issue provided $38,318,400 to the 
company. These funds were used to the extent of $27,150,000 to retire 
all the previously outstanding preferred stock while the remainder, 
$11,168,400, was earmarked for the expansion program. 

When this new convertible preferred was being worked out, market 
conditions led the directors to plan to make the conversion privilege on 
the basis of $41 per common share, but as the market advanced from 
about $38 during the period of making plans and registering the issue 
the conversion basis was changed to $45, and finally to $50 per share or 
two common shares to one preferred share. The management felt that 
these shares would be converted in the future because the common had 
often sold on the basis of 20 times earnings. Since the budgeted earnings 
were $4.00 per share of common stock, the management believed that 
the price of the common might well reach $80 per share. Ludlow, Mil- 
ner & Co. advised the directors that to make a convertible feature at- 
tractive the conversion rate could not be more than 10% above the 
current market for the common. If the conversion feature was to become 
attractive to buyers who wanted quick profits it was deemed advisable 
to place the conversion price at not more than 5 % above the market 
price of the common. 

If the common shares could have been sold directly at $50 per share, 
the directors would probably have used this method to raise the re- 
quired funds. However, Mr. Knowles believed that a proposal to issue 
about 250,000 common shares would depress the market to the extent 
that it would not absorb the issue over $40. Therefore, a convertible 
preferred, convertible at $50 per share, was chosen in the hope that it 
would be converted into common in a short time. The directors an- 
nounced their intention of calling the preferred issue as circumstances 
warranted. 

From January 1 to March 15, 1946, the price of the common rose 



152 Case Problems in Finance 

from $38^ to $50 and the weekly volume of trading increased from 
4,500 shares to more than 12,000 shares. On April 1, the market was 
$50, and by Monday, April 8, the day the new preferred was issued, it 
had increased to $54|. By Wednesday of the same week it had fallen 
to $49 1 . The explanation given in market circles for this erratic move- 
ment was that the upward swing had its basis in the optimistic business 
prospects of the company, while the decrease that followed was due 
in part to the shares going ex-rights and also to the pressure of selling 
by common shareholders to secure funds to buy the preferred. In the 
succeeding week under the impetus of a strong bull market the price 
moved up to $56^ and once to a peak of $59| in the latter part of 
May, 1946. 

By June the new convertible preferred stock reached a peak price of 
$1351 per share, its high for the year, 1946. The course of the prices 
of both classes of stock in 1947 is shown in Chart 3 (p. l63). 

During the summer and early fall of 1946, the directors took up the 
question of further financing for capital expansion, and an issue of 
debenture bonds was favorably considered for the first time in company 
history. The majority of the board seemed to think that the company 
had an adequate base of junior securities outstanding and could justifi- 
ably issue a senior security. Mr. Knowles, who was of this opinion, 
reasoned that if $36,000,000 of debentures were sold, there would be 
only $74,000,000 in preferred stocks and bonds as compared with a base 
of $264,000,000 in common stock equity, measured by the market 
price. The idea of debt was a deviation from the directors' basic policy 
of "leaving the top open," but it was considered because it was felt that 
more time should be given for the market thoroughly to absorb the con- 
vertible preferred issue before additional preferred was issued. In this 
connection, the directors also had in mind their policy of calling the pre- 
ferred stock for redemption (at a price of $104.50 plus accrued divi- 
dends ) if the market price of the common shares was sufficiently above 
the "conversion price" of $52.25 ($104.50 -^2). 

On October 31, 1946, the company sold to five insurance compa- 
nies, at par, $36,000,000 of 2.65% debentures due in 1971. The bond 
indenture required that annual sinking fund payments of $1,200,000 
be commenced in 1957 in order to retire one-half the issue prior to 
maturity. There was no stipulation, however, limiting further issues of 
any type of security. 

After placing the bond issue, the directors took under consideration 



Cellulose Corporation 153 

actions which would force the conversion of the preferred shares into 
common. The common dividend was increased to a rate of $2.00 per 
share as of January 30, 1947. Conversion was then favorable to pre- 
ferred shareholders from the dividend aspect. Experience with the his- 
tory of convertible issues showed, however, that the majority of the 
preferred holders would probably not convert unless they were forced 
to do so by having their shares called for redemption. However, the time 
required to go through the procedure of call complicated the problem. 
Fifteen days' notice was required to be given to the New York Stock 
Exchange of the company's intention to call the security, plus 30 days' 
notice to the particular shareholders whose shares were called. While the 
directors desired to call all the preferred shares at the earliest time, they 
were reluctant to commit the company to the extent of $39,941,350 
over such a 4 5 -day period. If the market price of the common 
should decline below $52.25, most of the preferred holders would take 
the cash payment of $104.50 per preferred share. Therefore, it was 
planned to force the conversion of the issue by stages so as to minimize 
this risk. 

Chart 3 presents the 1947 course of the stock market prices of the 
common stock. In March, 1947, 11 months after the issue was sold, 
18,000 shares had been converted voluntarily. At this time the company 
called 76,800 of the preferred shares. With the market of the common 
fof the week ending February 21 at $57f-$59 and the weekly volume 
of trading at 6,000 shares the management did not feel that more could 
be called without risking the possibility of such action forcing the mar- 
ket below the conversion price. As it happened, the price went down to 
$53| on March 14, 1947. Volume of trading in this stock increased 
during the call period as compared with the general market volume. 
Practically all of the 76,800 called shares were converted. 

In the second quarter of 1947, during the period of a severe strike, 
the market price of the common stock fell to $49i; but by July 1, 1947, 
it had returned to $60-$ 60^ and the weekly volume of trading was in 
excess of 8,000 shares, which put the company in a position to force 
further conversion. Some of the directors strongly advised that the re- 
mainder of the stock be called, arguing that it was better to call all the 
shares at once to have the depressive effect on the price of the common 
over with in one operation. Other directors were hesitant, however, to 
incur the risk of having to secure $31,722,020 cash if the whole issue 
were called and conversion did not occur. They noted that the difference 



154 Case Problems in Finance 

between the effective call price of $52.72 ($52.25 plus accrued dividend 
of 47 cents per share) and the market price was only $6.00 or $7.00. 
The directors that favored calling all the issue felt that the answer to 
this problem was to refrain from calling any of the preferred until the 
market price of the common was high enough to assure a successful 
conversion of the whole issue. To them the essential thing was to do all 
the forcing in one operation. However, unanimous consent to this course 
of action could not be secured and a compromise was decided upon 
whereby 144,000 shares were called as of September 12, 1947. This 
involved a risk of $15,048,000, an amount which the company could 
subtract from its net working capital of $41,400,000 without imperiling 
its finances. Almost all the shares were converted into common, as the 
market price did not decline below $56|. This left about $12,000,000, 
par value, of the original $38,000,000 issue outstanding. 

It was hoped to call the remainder of the issue shortly after the call 
in September, 1947. When the time came the directors did not think 
this was feasible because during the third quarter the company experi- 
enced lower earnings than were generally expected. The directors did 
not wish to take the responsibility of having the preferred shares con- 
verted before the earnings results were made public. Actually, publica- 
cation of the third-quarter earnings data had little effect on the market. 
By this time, however, insurance companies had withdrawn temporarily 
from the purchase of new preferred stock issues, and the directors felt 
that there was no practicable method of securing long-term funds to re- 
place cash used in the event that the market for the common suddenly 
declined after notice of call. Therefore, no further call was made upon 
the 3i% preferred shares. As of December 31, 1947, 220,800 shares 
had been called for redemption, 220,049 of which were converted into 
common shares and 751 redeemed. In addition, 49,602 shares had been 
voluntarily converted at various times, leaving 109,958 shares still out- 
standing. 

In the same period the directors were making plans to raise the re- 
maining $30,000,000 required for the expansion program. The idea of 
an issue of common was rejected. The directors did not wish to take any 
action which might depress the price of the common while conversion 
appeared likely. 

The board absolutely refused to consider any further issue of deben- 
tures because of the risk involved. However, a suggestion to sell 3i% 
nonconvertible cumulative preferred stock was considered. It was ar- 



Cellulose Corporation 155 

gued that such a security would provide not only permanent capital but 
also a leverage factor for the benefit of the common shares. However, 
Ludlow, Milner & Co. pointed out that the investing institutions, the 
major market for such an issue, had become more selective regarding 
preferred issues in recent months and had been insisting on 2 % sinking 
funds in ordinary preferred stock contracts. Several directors of Cellulose 
Corporation considered such a sinking fund highly irrational, for it 
would, in effect, put a maturity on the security so that the leverage ad- 
vantage "would weaken and finally disappear." They also argued that 
such an arrangement would, with dividends, involve an "annual cost" of 
from 5% to 6%, which they considered altogether too much in the 
light of the credit standing of Cellulose Corporation. 

In late October, 1947, the management felt out certain insurance 
companies to see whether a preferred stock on a 4% basis without a 
sinking fund would be acceptable. It was found that they would be in- 
terested in such an issue because of the rate quoted. The directors then 
decided to proceed on this basis, and so the company, through Ludlow, 
Milner & Co., immediately prepared to make a public offering of a 
straight preferred to yield about 4 % . A registration statement was filed 
with the SEC early in November. 

During the "waiting period" the market for new preferred issues 
became unsettled. This market was unusual. Although existing issues 
remained somewhat stable, new issues, although comparable, had to be 
sold at higher yields. An example of this unusual situation was Southern 
Utilities Corp. 4^% preferred which had to be sold at par to yield 
4.50%. Comparable outstanding issues were selling around a 3-90 basis. 
Similarly, Ludlow, Milner & Co. considered that it would have been 
difficult to sell a $30,000,000 Cellulose 4^% issue at par, although an 
already outstanding Union Viscose & Chemical 4% preferred issue, 
which in many respects was comparable, was selling on the market at 
$103-$ 105. In addition, insurance companies were no longer interested 
in any preferred stock without a sinking fund. The directors of Cellulose, 
learning that a successful offering of an issue of the size contemplated 
could not be assured on what they considered reasonable terms, decided 
to postpone indefinitely the sale of straight preferred stock; and the 
registration with the SEC was withdrawn. Despite the delay in financ- 
ing, it was necessary to make large commitments for machinery; and 
so Mr. Knowles arranged with a group of banks to borrow on five 
days' notice up to $12,000,000 on or prior to February 1, 1948, and an 



156 Case Problems in Finance 

additional $18,000,000 on or prior to April 1, 1948, at 2^% interest, 
the loans to mature January 2, 1951. The finance committee of the 
board of directors considered this a temporary expedient because they 
did not like "to finance bricks and mortar by means of three-year bank 
credit." On the other hand, the arrangement gave the management the 
satisfaction of knowing that, if necessary, they could wait up to three 
years to put this financing on a permanent basis. The company borrowed 
$12,000,000 on this credit almost immediately, although it did not 
spend it. 

Mr. Knowles, chairman of the finance committee of the board of 
directors of the Cellulose Corporation, had been a partner of Ludlow, 
Milner & Co. up to World War II, when he entered the government 
service in a high administrative capacity. After the war he devoted all 
his time to financial consulting. He was director of several large corpora- 
tions. 

Late in December, 1947, Mr. Knowles had several talks with the 
partners of Ludlow, Milner & Co. Feeling that he should put before the 
finance committee the alternatives that were open, he called a meeting 
for January 5, 1948. He opened this meeting with a summary of the 
financial program of 1946 and 1947. He then pointed out that world 
conditions were unsettled and that talk of war was becoming more and 
more common. Interest rates had risen; yet all the bankers he had talked 
with were agreed that money rates were still low with reference to long- 
run experience. Mr. Knowles felt that it would be wise for the company 
promptly to replace the three-year bank loan with permanent capital, 
for there was no reason to think that interest rates would be more attrac- 
tive during the life of that loan. 

Mr. Knowles presented five alternatives to the committee. The first 
was the current arrangement with the banks, the limitations of which 
he felt required no further amplification. Second, he was confident that 
the company could sell $40 million of additional debentures to insur- 
ance companies and banks at very favorable rates, say 2.65%. This sale, 
however, would further modify the company's established policy to 
"leave the top open" for future needs. He pointed out that the total 
assets of the company had increased from $14,600,000 in 1928 to 
$165,000,000 in 1947 and profits before taxes had increased in the 
same period from $1,291,000 to $30,880,000. Because of this dynamic 
growth he thought it would be wise to refrain from selling senior secu- 
rities if other alternatives were available. 



Cellulose Corporation 157 

One of the committee members expressed the thought, however, 
that the common shareholders might well complain that the manage- 
ment was being too cautious. He pointed out that other progressive and 
capably managed companies in the industry had financed a much greater 
proportion of their capital needs by debt. Another committee member 
countered this argument by remarking that the common stockholders, 
almost all of whom were small holders, had shown no signs of dis- 
pleasure with the financial policies to date. 

A third alternative was for the company to sell a $30,000,000, 4% 
preferred stock issue. Mr. Knowles believed that there was still very 
much a buyers' market. He estimated that a 3 % sinking fund would be 
required as compared to the 2 % sinking fund considered in November, 
1947, if the stock were to sell at a reasonable price. The discussion 
showed that some of the directors were strongly of the opinion that an 
issue with such a sinking fund was altogether too costly if 7% were 
required for dividend and sinking fund and, furthermore, would not 
meet their desire for permanent capital. It was little better than "a de- 
benture issue with a tax disadvantage," as one director phrased it. 

As a variation of this alternative Mr. Knowles said that Ludlow, 
Milner & Co. had advised him that a preferred issue could be sold with- 
out a sinking fund, but it would require a 4^% dividend. The bankers 
considered this out of line with the long-run credit rating of the com- 
pany. One of the members of the finance committee noted that recently 
the Eastern Electric Company had successfully sold a $7,500,000, 4.3% 
preferred issue without a sinking fund. Mr. Knowles informed him that 
the reason for the success of this issue was that it was relatively small 
and could be marketed without having to rely upon the life insurance 
companies to take any of it. The problem of placing an issue of 
$7,500,000 was much simpler than that of placing one of $30,000,000. 

A common stock issue offered a fourth alternative. It had the ad- 
vantage of being permanent capital as well as enlarging the base upon 
which bonds could be issued in the future. Mr. Knowles said that Lud- 
low, Milner & Co. would be willing to underwrite such an issue. With 
the current market $5 8-$ 60 for the common shares, he had talked with 
the bankers in terms of an issue at a price to the public of from $47 i to 
not more than $50. To this proposal one of the members raised the ob- 
jection that he did not think it was good policy to sell shares at $50 and 
invite criticism if the market should subsequently decline. Such a slump 
was possible, he thought, because in the fourth quarter of 1947 Cellu- 



158 Case Problems in Finance 

lose Corporation earnings had been poorer than investment publications 
had forecast. This member said that he favored waiting until the earn- 
ings had returned to "where they should be." 

The fifth alternative, which Mr. Knowles favored, was to sell an- 
other issue of convertible preferred stock. Ludlow, Milner & Co. was 
confident that such an issue would have a strong appeal to investing 
institutions because it offered them an opportunity to participate in the 
common stock market. In fact, a convertible feature would be more 
acceptable than a sinking fund. In commenting on this alternative, Mr. 
Knowles said that he would consider it as a "dressed-up common," 
rather than a "sugared preferred" issue. In effect, it would enable the 
company to issue common shares at a favorable price and at the same 
time hedge against the effects of a drop in common stock prices during 
distribution or soon thereafter. 

With reference to the various alternatives, Mr. Knowles pre- 
sented a set of dilution tables, as shown in Exhibit 2, which dealt with 
financing the expansion by selling bonds, preferred stock, or common 
stock. He stated that he estimated that common shares would have to 
be sold at least for $47 in order to prevent any dilution of earning power 
if normal earnings were assumed to be $28,000,000. However, he 
thought that this level of earnings was very conservative. 

Mr. Knowles said that the choice of convertible preferred presented 
some complex problems. With straight preferred issues the major factor 
of the yield basis required the adjustment of price and dividend rate. The 
matter of the proper yield basis, of course, was not simple. If it resulted 
in a price two points too low, much demand would be created and so 
turn the stock into a "hot issue," which would get into speculative hands 
rather than remain placed with investors. On the other hand, if the price 
were two points too high, the issue would probably have little appeal. 
With a convertible issue there were three factors: price, dividend rate, 
and conversion price. The accepted range for conversion was between 
5% and 10% above the market of the common stock at the time of of- 
fering. Generally speaking, if the conversion price were set relatively 
high, making the possibility of conversion remote, the yield basis would 
have to be set higher. Contrariwise, if a low conversion rate were set, 
making possible profitable conversion in the near future, the yield rate 
could be lower. In this case, the issue would tend to appeal to investors 
with a "common stock outlook." However, if the conversion price were 
set too close to the market, the issue might go largely into speculative 



Cellulose Corporation 159 

hands. If speculators forced the price up shortly after the stock was is- 
sued, common stockholders might take the price increase as evidence 
that the issue had been underpriced and they might, therefore, criticize 
the management if they had not been given prior right to subscribe to 
the issue. 

Again, if the conversion price were set at a low level it might tend 
to depress the long-run price of the common. This was so because once 
the market price of the common got above the conversion price there 
was always a potential danger of large-scale conversion. Inasmuch as 
during 1947 the common had always been subject to this threat, Mr. 
Knowles felt that it was deserving of some relief for a while. He thought 
that it might bring disfavor on the management if, each time Cellulose 
stock showed a strong bullish tendency, the directors took action which 
forced the market to retreat. 

As a matter of detail, Mr. Knowles said that any preferred issue 
should be so set up as to avoid any confusion between it and the 3i% 
preferred, of which a small amount was still outstanding. The dividend 
rate and the conversion price should differ in the two issues. Also, at- 
tention would have to be given as necessary to the clause in the existing 

Exhibit 1 

CELLULOSE CORPORATION 

Balance Sheet as at September 30, 1947 

(Dollar figures in thousands) 

ASSETS 

Current $ 70,954 

Investments and miscellaneous assets 3,491 

Land and plant $141,906 

Less: Depreciation 54,430 87,456 

Deferred charges 1,987 

$163,888 

LIABILITIES 

Current $ 17,546 

Advances — noncurrent 425 

Debentures, 2.65% due 1971 36,000 

Pension reserve . 7,042 

Capital stock and surplus: 

Preferred, 3i%, $100 par, convertible, outstanding 

122,871 shares $ 12,287 

Common, no par value, outstanding 5,077,796 shares . 25,388 

Surplus 65,200 102,875 



$163,888 



Chart 1 



CELLULOSE CORPORATION 

NET TANGIBLE ASSETS, GROSS PLANT. AND 

NET PLANT 1928 -1947 



Millions of Dollars 
150 



125 



100 




1928 1930 



1935 



1940 



1945 1947 



Chart 2 



CELLULOSE CORPORATION 
Millions of TREND OF NET SALES AND EARNINGS 
Dollars 1928-1947 

225 




Other Costs 



Depreciation 
Toxes 

Net Profit 



1928 1930 



Cellulose Corporation 



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164 Case Problems in Finance 

preferred contract, which read as follows: "The conversion price shall 
be reduced if the company issues any additional shares of common stock 
[other than shares of common stock issued upon conversion of shares of 
Cumulative Preference Stock, 3i% series}, without receiving therefor 
a consideration per share at least equal to the conversion price then in 
effect, and the conversion price shall be increased if the company com- 
bines its outstanding shares of Common Stock." 

Market conditions were described in Business Week, January 10, 
1948, as follows: 

One reason for the better feeling among underwriters is the behavior of the 
corporate bond market. . . . Apparently the corporate market took its medicine 
all in one dose. Since the first drop it has tended to firm up. 

Another and more important factor: Right or wrong the trade has become 
convinced that a huge amount of invested institutional funds has built up in re- 
cent weeks. Bond men are confident that the pressure of these funds will break 
the buyers' strike of life insurance companies and other institutions. 



f^^^^v^^^A\vv\vvvvvvvvvvvwvvvvvvvvvvvvvvvvwvvvv^Avvvw>^^^ 



Jay Textiles, Inc. 



%VVVVVVVVWAVVVVVVVVWM\VVVVVVWV\AAV\\VVVVVVVVVVV\VVVVVVV^^ 



Jay Textiles, Inc., operated several cotton and rayon textile mills in 
a southern state. These mills were first established by separate interests. 
They were consolidated under single ownership during the 1920's. The 
consolidated company was reasonably prosperous until the depression of 
the 1930's, when it found itself under financial strain, as did most con- 
cerns in the textile industry. Fortunately, Tarheel Bank and Trust Com- 
pany, the company's bank, gave assistance in the form of short-term 
renewable loans as necessary during this period; and so the company 
continued to operate without a financial crisis. This strong support was 
accorded in part because the bank considered the company one of the 
basic industries in the state and felt that by assisting Jay it was at the 
same time promoting the general welfare of the community. 

Improved earnings during the war, shown in Exhibit 1 (p. 175), 
and the optimistic outlook for the textile market caused Mr. Bergen, the 
president of the company, to propose to the bank in 1945 a scheme of 
refinancing the floating debt. He also planned a modernization program 
which it was felt would put the company on a firm and profitable basis. 
Engineering studies indicated the need of spending $7,300,000 over a 
three-year period. About $1,200,000 was the minimum for 1946. 

When the refinancing plan was agreed upon in 1945, it was the in- 
tention of the directors to refund the short-term bank debt of $5,000,000 
by selling serial notes or debentures to life insurance companies. A 
committee appointed by the directors on December 3, 1945, to investi- 
gate such possibilities reported that insurance companies were reluctant 
to purchase the obligations of textile companies because of the poor 
earnings record of the industry and its cyclical nature. The committee 
recommended the acceptance of an alternative proposal advanced by 
the bank but emphasized that such a proposal was to be construed purely 
as an interim expedient while a more permanent and favorable form of 
capitalization was sought. 

165 



166 Case Problems in Finance 

The Tarheel Bank and Trust Company had offered the following 
arrangement: 

1. $1,750,000, 2|% unsecured loan, to be repaid in $100,000 semiannual 
installments, commencing one year after date. 

2. $3,250,000, 3% unsecured loan calling for sinking fund payments, 
beginning with 1946 earnings, of 40% of the annual profits in excess of 
$1,000,000, but less than $2,000,000, and 20% of the annual profits in excess of 
$2,000,000. The sinking fund would be due March 1, annually, but only from 
March 1, 1947. 

The bank, in offering the above rearrangement of its loan, em- 
phasized that the terms of the 3 % loan were designed to force the com- 
pany to retire it as soon as possible. It stated that either loan could be 
retired in whole or in part at any time without penalty. 

The directors agreed to the proposal, and the loan agreement was 
signed on December 22, 1945. 

At a meeting of the directors held late in December, Mr. Levin, 
treasurer of the company, was asked to investigate ways and means of 
refunding these bank loans with permanent capital at the earliest oppor- 
tunity. 

At the close of 1945, the outlook for the cotton and rayon industry 
was particularly bright. Stocks of goods in distribution channels were 
largely depleted, and consumer buying power gave every indication of 
remaining at a very high level for many months. The historical problem 
of the textile industry, that of overcapacity, appeared to have been 
largely alleviated. The number of spindles in operation in 1925 had 
been 37,872,000, while in 1944 the reported number was 23,108,000, 
a decrease of 39%. Furthermore, foreign competition was negligible 
because of the dislocation caused by the war in Europe and Japan. The 
prospects of an increased and more efhcient labor supply and the possi- 
bility of obtaining new and faster machinery were additional favorable 
factors. Such factors, coupled with the elimination of the excess profits 
tax, made the future of the cotton industry appear particularly favorable. 

Conditions in the securities markets at the end of 1945 and early 
1946 were "strongly bullish." The most outstanding feature of this 
period was the intense demand for investments, which resulted in 
driving down the yields on securities to abnormally low levels. Further- 
more, the investing public was showing less and less discrimination in 
selecting securities. This development was reflected in the lessening dif- 
ferential in yields between different grades of securities. 

Quotations (paraphrased), taken principally from Barron's, will be 



Jay Textiles, Inc. 167 

inserted in this case at certain points to enable the reader to gain "a feel 
of the market" as the case progresses. The first of these follows: 

January 14, 1946 

In the greatest surge of strength since the current phase of the rise began in 
the week after V-J Day, all three major groups of stocks — industrial, rail and 
utility — pushed last week to new high prices. . . . On all counts, activity and 
extent and length of rise — the advance of last week is noteworthy in the annals 
of the long bull market. . . . Moreover, in the upheaval of prices a great change 
has occurred in the yields. When the bull market commenced, the industrial 
stock average yielded 7^% and the rails 81/4%, against a rate of 2M% from 
prime bonds. In other words, there was a spread in favor of industrial stocks of 
nearly 5%, and for rails 5M%. By July, 1943, the industrial yield was down to 
4%%, with the advantage over bonds V/%%. Now, above 200, the industrials 
yield 3%%, or % of 1% more than bonds, while the rails give 41/^ %, or 1%% 
more than prime bonds. The evolving story of yields indicates how far the market 
has proceeded in discounting the peace boom. 

January 28, 1946 

Record high prices being established for both government and corporate 
bonds are furnishing convincing proof that the country actually is running short 
of places to put investable funds. 

March 4, 1946 

Only twice before in 15 years has the stock market declined so much in a 
single session as the 8.39 point break in the Dow- Jones industrial average which 
ushered in the last week of February. . . . Recovery in stock prices which set in 
at mid-week left unanswered the question as to the cause of this decline. 

March 7, 1946 

M. Lowenstein & Sons, Inc. 

75,267 shares, 41/4% preferred, $100 par, was offered today at $104 per 
share (proceeds to company $101.50) by Eastman Dillon & Company. 

Following the instructions of the directors as given in the meeting 
of December 28, 1945, Mr. Levin submitted the following report for 
discussion at the directors' meeting of March 21, 1946. The report in- 
cluded the balance sheet of December 31, 1945 (shown in Exhibit 2). 
The text read: 

MEMORANDUM 

A — Factors to Be Considered and Assumptions Used 
IN Financing Study 

1. Working Capital 

During the fall of 1945, Jay was operating with a net working capital of ap- 
proximately $10,550,000. Because of capital expenditures this was subsequently 



168 Case Problems in Finance 

reduced to about $9,730,000 as at December 31, 1945. As of February 23, 1946, 
it had increased to about $9,850,000 as a result of two periods of earnings with 
relatively small capital expenditures. 

As at December 31, 1945, cash balances stood at $2,437,441. While this ap- 
peared to be large, it is being rapidly absorbed by increases in other current assets. 
As has been expected, it has been melting away and in all probability will not 
accumulate rapidly, if in fact it holds its own. The existence of this excess cash 
and its availability to absorb inventories, etc., does not increase net working 
capital. 

As a convenient yardstick, sales of $50,000,000 for the year will represent a 
daily turnover at the rate of $200,000 a day for the approximate 250 days of 
operations. The rapidity with which a million of cash can disappear with this 
volume of business is readily apparent. 

A specific item which may absorb a very substantial amount of cash is the 
expansion of the dress goods program in which the turnover is slower and the 
cash tie-up relatively larger. 

In general, we anticipate a further rise in the cost level. This will be reflected 
gradually in the receivables- inventories block of assets which stood at $8,611,000 
at December 31, 1945, and is now about $9,780,000. We also know that the 
volume of business is on the upswing with the increasing number of employees 
at work in the mills. This will also mean an increase in the receivables-inventories 
block of assets. 

My guess, which is all that it can be at this stage, is that Jay should have at 
least 11 millions of working capital, preferably 12 millions, if it is to operate 
freely at this cost level and keep out of the banks. 

For the year 1946 I therefore include $1,700,000 for additional working 
capital. 

2. Note Maturities and Sinking Funds 

The only maturity in 1946 is $100,000 on the 2M% serial notes on Decem- 
ber 22. 

The contingent sinking fund on the $3,250,000 note is not payable until 
March, 1947. The amount to be paid is predicated upon earnings and must be 
provided for out of current earnings. In order to have figures to work with, as- 
sume 1946 earnings to be $2,800,000 after all charges. The contingent sinking 
fund would be $560,000, which together with the fixed maturity would pull 
$660,000 out of our cash position. 

On the other hand, if we refund the two bank notes during 1946, it will 
require $5,000,000. The bank does not require a premium for retiring the loan 
before maturity, nor is it anxious to have any prepayments. I have just checked 
this with Mr. Randall at the bank. 

3. Capital Expenditures 

The amount to be spent during 1946 is dependent upon the availability of 
machinery and materials rather than on the desirable and potential field for mak- 
ing additions and replacements in the five mills. 



Jay Textiles, Inc. 169 

The amount to be spent in any event is controllable in some degree and can 
be reduced or expanded to fit our pocketbook. 

In order to develop a refinancing program, assume an aggregate of 
$1,200,000 of capital expenditures during 1946. 

4. Dividends 

In accordance with our policy of paying $1.50 per share per annum on the 
common, we must set aside $652,500. 

5. Cash Availability from Operations 

Earnings assumed earlier $2,800,000 

Depreciation (at rate allowed by Bureau of Internal 

Revenue) $ 361,000 

Depreciation (additional necessary for adequate re- 
placement) 261,000 622,000 

Cash accruing from operations $3,422,000 

B — Summary of Financial Position 

(A) Assume no refinancing in 1946 

1. Provide for additional working capital $1,700,000 

2. December 22 note maturity $ 100,000 

Contingent sinking fund 360,000 660,000 

3. Capital expenditures 1,200,000 

4. Dividends at rate of $1.50 for the year 652,500 

$4,212,500 

5. Cash from operations: 

Assumed earnings $2,800,000 

Depreciation charges 622,000 3,422,000 

Indicated shortage $ 790,500 

Comment: The indicated shortage approximates the note maturity and con- 
tingent sinking fund. The borrowing of this amount as a current bank loan for 
working capital has the effect of substituting current debt for the long-term debt. 

(B) Assume refinancing in 1946 

1. Provide for additional working capital $1,700,000 

2. Note maturity and sinking fund (Eliminated) 

3. Capital expenditures 1,200,000 

4. Dividends at rate of $1.50 for the year 652,500 

3,552,500 

5. Retirement of bank loans 5,000,000 $8,552,500 

6. Cash from assumed earnings . . ,$2,800,000 

7. Cash from depreciation charges 622,000 3,422,000 

Indicated need $5,130,500 

Comments: The above figures are assumptions to establish a general financial 
pattern and demonstrate the end results simply. The basic assumption is that we 
are faced with a year of good business with high earnings. The corollary of this 
assumption is more working capital, a heavy sinking fund accrual, and pressure 
to improve the productive plant. 



170 Case Problems in Finance 

Assuming that cash is not developed from current operations in an amount 
sufficient to provide for all the desirable objectives, we have two alternatives: 
{a) to cut back the objectives to fit our pocketbook, (^) to borrow. While the 
latter is entirely in order, it has the effect of shifting a piece of the long-term 
bank debt to short-term bank debt. 

Assuming that cash is not produced from a refinancing operation in an 
amount sufficient to clear the financial decks, we are again left facing the same 
alternatives of where to cut and at what point to borrow. The latter alternative is, 
however, less objectionable after the elimination of all of the long-term bank 
debts. 

A partial financing of the long-term bank debt does not solve the problem 
from the company's viewpoint. If anything, it leaves the company with a poorer 
financial setup, consisting of current bank loans, serial bank debt, a debenture or 
preferred issue of some kind, and common stock. Two layers of bank debt ahead 
of a junior issue would not make the junior issue a prime piece of paper, and the 
existence of three capital layers ahead of the common would not be desirable for 
the common stock. 

Conclusion: If financing is to be undertaken, it should be in a minimum 
amount of $5,500,000. 

C — Alternative Methods of Financing 

There are innumerable combinations possible, and only the major alternatives 
are commented upon. 
The assumptions are: 

A. We want to raise about $5,500,000 of cash if we are going after public 
financing. 

B. The financing should be designed to point towards an eventual end re- 
sult of an all-common stock capitalization. 

The two extreme possibilities are: 

L Debt financing. This can be in the form of long-term mortgage bonds, 
shorter term debentures of some kind, still shorter term serial notes. 

Comments: Creating $5,500,000 of debt to replace $5,000,000 of 
existing debt is not progressive in itself. While a new form of debt 
would have a longer maturity than the 8^/2 -year bank loans now exist- 
ing, the inherent problems of sinking fund or serial payments would 
still be with us, although at a possibly slower rate. Publicly held debt 
obligations may or may not be an advantage in contrast with having to 
work out any problems with one friendly creditor. 

2. Common stock financing. This is an ideal method in theory. Assuming 
stock salable at $40 a share and the issuance of additional shares on the 
basis of one new for each three presently outstanding (or 145,000 new 
shares), this would produce roughly $5,800,000 net of cash, a very de- 
sirable result. 



Jay Textiles, Inc. 171 

Comments: The market for Jay stock fluctuated widely in 1945. 
Since January 1, the market has cHmbed from about 34^ bid to about 
41. Problems of underwriting, voting, dilution, and cost of the addi- 
tional capital are obviously of moment. 
Conclusions: I advise against either of the extreme methods at this time. 

Intermediate Methods 

Create a preferred stock, the major alternatives being a straight preferred or 
a convertible preferred. 

Straight Preferred. From the standpoint of financial setup a great improve- 
ment over debt. From the viewpoint of the common, it creates a senior charge 
higher than that now existing and the preferred dividends would not be a tax 
deduction as is the interest on the loan. This is not a monumental difference, and 
the additional working capital and elimination of debt are contra considerations. 

Other considerations are: call price on such an issue, possible retirement 
funds from operations, voting rights in the event of dividend accruals, possible 
limitations in regard to incurring debt and maintenance of working capital posi- 
tion as they might affect the paying of common dividends. 

Convertible Preferred. This may offer somewhat greater advantages than 
the straight preferred, more particularly as to price, voting rights, restrictions, 
and retirement provisions. It also points directly towards the end objective of a 
common stock capitalization. 

The objections at this time are somewhat similar to those applying to a com- 
mon stock issue, although in a much less intense degree. Another general prob- 
lem, and one that will always exist, is that of setting the conversion rate, a formula 
which necessarily looks into the future. 

Possible Alternative. The sale of $5,500,000 straight preferred, and calling 
it later through the sale of additional common stock. Obviously more expensive, 
as it means two steps. 

Conclusions: The relative terms which could be traded out with an under- 
writing group might be the decisive factors as between a straight or convertible 
preferred. We are in a position to create, within reason, the type of stock best 
fitted to our requirements. 

As between the two broad types, my preference is for the convertible pre- 
ferred. 

Possible Combination of financing 

The problems of raising about $5,500,000 have been the subject of extended 
informal discussions. These have included the possibility of raising part of the 
cash through the sale of some type of preferred, say $3,500,000, in order to reduce 
the balance to be raised through the sales of common. As the discussions have 
progressed, the enthusiasm for this type of package has steadily decreased, the 
selling of the additional common being the drawback. 

Conclusion: I recommend against undertaking this general form of package 
financing. 

August Levin, Treasurer 
Submitted March 21, 1946 



172 Case Problems in Finance 

After considering the report, the directors agreed with Mr. Levin 
that the problem should be given more intensive study during the next 
few weeks. Mr. Troster, representing Ford & Troster, Inc., on the board 
of directors, questioned the advisability of issuing convertible preferred. 
He favored a "straight preferred" because he thought that in a couple 
of years the earnings of the company would prove so satisfactory that a 
much higher price could be secured for the common by selling it directly 
than would be possible by selling convertible preferred at the current 
time. He explained that, at the current time, it might be possible to put 
out preferred shares convertible on a three-for-one basis. This would 
mean that if the shares were converted the company would be selling 
the common shares for approximately $35. If, however, in two years' 
time common shares were sold directly, a price of $45 or $50 might be 
obtained, resulting in a gain which would far outweigh any current ad- 
vantage in price between a convertible preferred and a straight preferred. 
Mr. Repucci, the representative of Mid-Central Securities Corporation, 
agreed with Mr. Troster's argument and proposed that the matter should 
be studied further by Mr. Levin. 

One of the directors, Mr. R. C. Milner, advocated a bond issue, argu- 
ing that it would yield a saving of at least ^ of 1 % in interest as well as 
a saving in taxes. However, the other directors seemed to feel that the 
industry was too cyclical to incur any fixed charges such as would result 
from such an issue. Mr. Bergen proposed that Mr. Levin be authorized 
to open negotiations with Ford & Troster, Inc., in order to put forth con- 
crete proposals for consideration at the next board meeting. After Mr. 
Troster and Mr. Repucci absented themselves, the board unanimously 
concurred with Mr. Bergen's motion. 

March 27, 1946 
Hollingsworth & Whitney Co. 

42,000 shares, $4 preferred, was offered today at $105 (proceeds to the com- 
pany $103 per share) by Paine, Webber, Jackson & Curtis and Harriman Ripley 
& Company. 



^ During 1943 two large holdings of Jay common shares were redistributed through 
the houses of Ford & Troster, Inc., and the Mid-Central Securities Corporation. At that 
time it was arranged that each of these houses should have a representation on the board 
of directors. 

Ford & Troster, Inc., was a small investment house that had its principal customer 
connections in a three-state area around Atlanta. It had acted as principal underwriter for 
a number of successful industrial issues, forming successful selling groups extending over 
a much larger region. The Mid-Central Securities Corporation was one of the largest origi- 
nating houses, participating in many distributions on a nation-wide basis. 



Jay Textiles, Inc. 173 

Mr. Levin and Mr. Bergen gave the refinancing problem much con- 
sideration during the next week, both coming to the conclusion that Mr. 
Troster's argument had much validity and that they should seek financ- 
ing by means of straight preferred stock. 

April 8, 1946 

Biggest advance since the first recovery week of March 4 took place in the 
stock market last week. There also occurred the largest single gain, on Wednes- 
day, since the low levels of February 26. 

. . . But the most dramatic evidence of the intensity of the public demand 
for stocks is found in the extraordinary premiums placed upon two public offer- 
ings. Common stock of Alexander Smith & Sons Carpet, publicly financed for the 
first time, rose from an offering level of 31 to 41, and Publicker Industries 
common (industrial chemicals and alcoholic beverages) reached 31 in the out- 
side market, as compared with the initial figure of 23. 

April 15, 1946 

Another burst of strength last week carried industrial stocks to a new high 
level for the four-year rise. 

On April 15, 1946, Mr. Levin had lunch with Mr. Oliver, who was 
in charge of the buying department of Ford & Troster, Inc. Mr. Oliver 
agreed completely with Mr. Troster's reasoning about the conversion 
privilege. However, he did not think that it would be wise to attempt to 
sell $5,500,000 preferred, being confident that both the Mid-Central 
Securities Corporation and Ford & Troster, Inc., could place $4,000,000 
in "strong hands." To place $5,500,000 for such a company as Jay 
would mean that some reliance would have to be put on the speculative 
element of the market, while it was preferable to sell only to those in- 
dividuals seeking income investments. Mr. Oliver also explained that 
the dividend rate of the preferred stock, the price, and the spread allowed 
to the underwriters would depend on market conditions at the time of 
initial offering. Naturally, if the market was strongly "bullish," a much 
better rate, price, and spread could be given than if the market was 
"cautious" or still again "bearish." 

Mr. Oliver pointed out to Mr. Levin that as far as details of such a 
preferred issue were concerned the style factor entered into the framing 
of them just as surely as it did into dress designing. Each preferred stock 
had variations in order to meet the peculiarities of the industry and com- 
pany concerned, but the general outlines of such provisions were the 
same. The current preferred stock style set approximate limits as to 
what extent these numerous details were subject to negotiation. Mr. 



174 Case Problems in Finance 

Oliver then described in broad terms the current market attitude toward 
textile securities and what might be required "to take the security out 
the window" rather than having it left "on the shelves." Mr. Oliver 
finally urged Mr. Levin to expedite the negotiations as much as possible, 
for the market appeared to be developing signs of instability. 

After considering the foregoing discussion, both Mr. Levin and Mr. 
Bergen concluded that an issue of $4,000,000 was worse than none at 
all. If this were netted by a preferred issue, an additional $1,500,000 
would have to be raised by some other means, probably bank loans. Both 
were agreed that it would be better to stay with a friendly bank until 
the market was receptive enough to take up the $5,500,000 desired. 

The following week, on April 23, Mr. Levin and Mr. Bergen met 
Mr. Oliver in the latter's office. Mr. Oliver brought out from his files 
several prospectuses of recent textile preferred issues which served as a 
basis for discussion of the possible provisions in the proposed Jay issue. 
Before the discussion had developed very far, the problem of the 
amount of such an issue came to the forefront. Mr. Levin pointed out 
that an issue of $4,000,000 would not be a solution to Jay's problem 
but would only complicate the financial setup of the company. Mr. Oli- 
ver replied that such a large issue would be extremely difficult to sell at 
a satisfactory price. Then Mr. Bergen suggested that perhaps the idea of 
putting out a preferred issue was premature at this time and that it would 
be more satisfactory to stay with the banks. He went on to say that in 
recent discussions with Mr. Randall of the Tarheel Bank and Trust 
Company he was assured that the bank, while recognizing the desirabil- 
ity of permanent financing, did not wish to convey the impression of 
trying to force the matter. It was quite willing to continue the existing 
arrangement as long as desired. The discussion ended with Mr. Oliver's 
promising to draw up tentative provisions for the proposed issue and a 
comparison of the various recent issues of textile preferreds. They hoped 
this procedure would speed the negotiations by enabling specific points 
to be discussed and decided upon. 

April 26, 1946 

Burlington Mills Corporation 

24,433 shares (being the unsubscribed portion of 100,000 shares offered to 
common shareholders) 3V^% convertible 2d preferred was offered today at 104 
by Kidder, Peabody & Company. 

On April 26, Mr. Levin received by mail from Mr. Oliver the out- 
line of the proposed preferred provisions (shown in Exhibit 3 ) , and the 



Jay Textiles, Inc. 175 

comparison of recent preferred issues (given in Exhibit 5). In a cover- 
ing letter, Mr. Oliver stated that he had inserted the details on Jay on the 
assumption of a $4,000,000 issue, realizing, however, that the matter 
had not been finally decided upon. Exhibit 4 shows the price range of 
Jay common stock from December, 1945, to April, 1946. 

On April 27, 1946, Mr. Oliver and Mr. Repucci called on Mr. Levin. 
Mr. Levin stated at this time that both he and Mr. Bergen were firmly 
convinced that it would be impractical to contemplate a preferred issue 
of $4,000,000. After having considered the matter in detail again, 
both parties finally agreed to continue negotiations on the basis of a 
$5,000,000 issue. 

Mr. Oliver said that the proposed provisions would stand as a basis 
for discussion. He said that he liked to set up a plan so that 'a preferred 
should always be as strong as when it was first issued." Mr. Bergen and 
Mr. Levin did not choose to question the provisions until they had more 
time to study each item. The rest of the day was spent in showing Mr. 
Oliver and Mr. Repucci the various plans. 

April 29, 1946 

Most observers were impressed by the purchase of a big insurance company, 
on a 2.55% basis, of $32 million Philip Morris 2%% debentures, which the 
company, following the disclosure of a collapse of earning power, had been un- 
able to market in early February. 

Exhibit I 

JAY TEXTILES, INC. 

Operating Results 1937-1946 

(Dollar figures in thousands) 

Net Profit 

before Net Profit 

Net Interest after All 

Year Sales and Taxes Charges 

1937 $19,670 $ 742 $ 112 

1938 15,195 1,119** 1,731'' 

1939 20,278 97 557'' 

1940 20,393 135" 926'' 

1941 32,444 3,403 2,195 

1942 41,993 4,333 1,443 

1943 39,195 4,275 1,152 

1944 40,340 4,891 1,065 

1945 36,783 3,654 957 

■^Loss. 



176 Case Problems in Finance 

Exhibit 2 

JAY TEXTILES, INC. 

Balance Sheet, as at December 31, 1945 

(Dollar figures in thousands) 

ASSETS 

Current assets : 

Cash $ 2,437 

U.S. Treasury notes in excess of tax estimate 217 

Accounts receivable — net 904 

Inventories 7,707 

$11,265 

Investments 249 

Fixed assets — net* 5,424 

Deferred charges 187 

$17425 

LIABILITIES 
Current liabilities : 

Accounts payable $ 901 

Accrued payroll 220 

Other accruals 414 

Provision for taxes — less treasury notes 3 

$1,538 

Bank loans 5,000 

Reserve for contingencies 166 

Capital stock — common, 435,000 shares 4,350 

Surplus : 

Capital 21 

Paid-in 5,134 

Earned 916 

$17,125 

* Reserve for depreciation, $4,519. 



Exhibit 3 

JAY TEXTILES, INC. 

Outline of Proposed Preferred Stock Provisions Prepared 

BY Ford & Troster, Inc. 

Preferred Stock to have no pre-emptive rights, to be fully paid and nonas- 
sessable. 

Call Prices — Call price $5 per share above the initial public offering price for 
five years, thereafter $3 per share above such price. For the Sinking Fund, call 
price $2 above the initial public offering price for five years and $ 1 above the 
public offering price thereafter. Accrued dividend to the date of call to be 
added to the above premiums in every case. 



Jay Textiles, Inc. 177 

Exhibit 3 — Continued 

Dividend Restrictions — No dividends on or redemption of junior stocks unless: 

A. Dividends and Sinking Fund payments are all up to date. 

B. Unless paid out of surplus earned after January 1, 1946, and then only if 
this earned surplus after such payment is at least 25% of the preferred 
stock outstanding. 

C. Unless net tangible assets are at least 200% of the preferred stock outstand- 
ing and funded debt. 

D. Current assets 150% of current liabilities after payment of dividends. 

Voting Rights — Preferred stock to elect — 

A. Two additional directors if four quarterly dividends are in arrears or if a 
Sinking Fund payment is in arrears for six months. 

B. A majority of the directors if eight quarterly dividends are in arrears or if 
Sinking Fund payments are in arrears for eighteen months. 



Two-third vote of preferred stock required 

A. Create any debt maturing more than one year from issue. 

B. To issue preferred stock having priority to the present stock. 

C. To sell, liquidate or lease substantially all the property of the company. 



Majority vote of preferred stock required to — 
A. Issue any additional preferred stock on a parity with this preferred stock 
and then only if after issuance net tangible assets are at least 200% over 
all the preferred and funded debt outstanding and combined annual interest 
and preferred dividend requirements are earned four times. 

Sinking Fund — Annual payments of 1% (until present term debt is retired) of 
the largest amount of preferred stock theretofore outstanding. After retirement 
of term debt annual sinking fund payments of 4% of the largest par value of 
preferred stock theretofore outstanding. Sinking Fund payments may be made 
in preferred stock bought in the market by the company but not at a cost in 
excess of the Sinking Fund call price. 



Exhibit 4 

JAY TEXTILES, INC. 

Price Range of Common Stock Quotations 

High Low 

December, 1945 32i 3U 

January, 1946 35 34i 

February 37| 36| 

March 42 41 

April 45 43i 



178 



Case Problems in Finance 



Exhibit 5 

JAY TEXTILES, INC. 

Comparison of Textile Preferred Stocks Prepared by 

Ford & Troster, Inc. 

(Dollar figures in thousands) 



Jay 

Netsales, 1945 $ 36,783 

Net profit, 1945 957 

Current assets 11,265 

Current liabilities 1,538 

Working capital $ 9,727 

Debt 

Preferred $ 4,000 

Common, no. of shares 435,000 

Market value common $ 16,530 

Book value preferred $361 

Net sales times debt and pfd 9.2 

Net profit % of net sales 2.6% 

Working capital per share pfd $243 

Earned per share preferred (annual 
basis): 

1945 $23.92 

1944 26.62 

1943 28.80 

1942 36.75 

1941 54.87 

Sinking fund 

Issued at — when 

Call price— until 

Then — until 

Sinking fund — call price 

MarketJ 

Dividend rate 

Yield 



M. Lowenstein 
& Sons, Inc. 


Kendall 
Company 


$49,731 


$ 49,616* 


1,717 


731* 


16,280 


15,924* 


3,667 


3,336* 


$12,613 


$ 12,588* 




5,000 


$ 8,000 


$ 4,000 


1,000,000 


400,000 


$35,000 


$ 12,000 


$265 


$267 


6.2 


5.5 


3.5% 


1.5% 


$158 


$187 


$21.50 




17.70 


$18.30 


24.10 


23.60 


28.00 


24.20 


29.60 


28.80 


3% 


1%-I960t 


104(3/7/46) 


103(4/1/45) 


108(12/31/47) 


108(4/1/55) 


107(12/31/49) 




104 


105(4/1/55) 


104 3/4 


108 


4i% 


$4.50 


4.05% 


4.17% 



Jay Textiles, Inc. 



179 









Berkshire 


Hollingsworth 


Burlington 


S. D. Warren 


Fine Spinning 


& Whitney 


Mills 


Company 


Assoc. ^ Inc. 


$ 17,923 


$108,199 


$ 15,895 


$ 36,143 


642 


4,993 


461 


1,813 


8,224 


37,590 


8,647 


12,512 


3,217 


9,168 


1,537 


1,760 


$ 5,007 


$ 28,422 


$ 7,110 


$ 10,752 


450 




3,620 




$ 4,200 


$ 15,000-4% 
$ 5,000-3^% 


$ 3,000 


$ 7,108 


388,000 


1,721,776 


101,387 


457,126 


$ 12,028 


$ 44,766 


$ 5,880 


$ 17,827 


$ 452 


$ 245 


$ 327 


$ 215 


3.8 


5.4 


2.4 


5.1 


3.6% 


4.6% 


2.9% 


5.0% 


$ 99 


$ 142 


$ 116 


$ 152 


$15.30 


$25.00 


$15.40 


$25.50 


14.30 


19.90 


17.90 


22.60 


17.40 


19.00 


17.10 


24.30 


22.30 


17.20 


12.30 


26.80 


31.30 


15.90 


26.00 


26.00 


lh% 


2% 


2% 




105(3/27/46) 


104(7/2/45) 


101.50(12/11/45) 


By recapitalization 


109(1951) 


108(1946) 


106.50(1950) 


105 


108.5(1953) 


107.50(1947) 


105.50(1955) 




107(1953) 


104 


104(1950) 




105 5/8 


99, 89| 


103^ 


126 


$4.00 


4%, 3^% 


$4.50 


$5.00 


3.79% 


4.03%, 3.91% 


4.35% 


3.97% 


* 1944. 








•1% through 1960, 2% 


thereafter. 






; : Sale price, or average 


of bid and asked price. 







VV\\VVVVVVVVV\\VWVVVVVVV\VVVVVWVV\\VVWVVVVVV\A\\VV\VWVA^^ 



Dixley Paper Company CB\ 



\VVVVVVVVVVVVV\VVVVVVVV\VV\\VV\VVVVWVVVVWVVWVVVV\VV\VVVWVV\V^ 



On February 5, 1946, the executive committee of the Dixley Paper 
Company decided, subject to vote of the directors and stockholders, to 
issue 50,000 shares of $4.00 preferred stock on the terms^ outlined by 
George Holmes, company treasurer. Word of this action soon spread, 
and Mr. Holmes received numerous visits from underwriting representa- 
tives. 

As Mr. Holmes had anticipated, his proposed terms were not well 
received. Nevertheless, a number of firms betrayed obvious interest, and 
the trend of their offers reinforced Mr. Holmes's belief that his terms 
would be accepted before very long. Accordingly, preliminary discus- 
sions with counsel were started with a view toward preparing the legal 
provisions pursuant to which the stock would be authorized and issued. 

On February 14, Mr. Holmes received a visit from John Wendell, 
an officer of the Massachusetts Mutual Society for Insurance on Lives. 
Mr. Wendell stated that he had heard that the Dixley Paper Company 
was contemplating a public offering of preferred stock. Mr. Holmes con- 
firmed that such was indeed the case and outlined the terms of the pro- 
posed issue. Mr. Wendell, who obviously was already acquainted with 
the terms, stated that his society was interested in buying the entire issue 
direct from the Dixley Paper Company at the proposed price to the un- 
derwriters of $103 a share. The society's intention would be to hold the 
shares until they were redeemed in accordance with the proposed Re- 
tirement Provisions. Mr. Wendell added, however, that as a condition 
of purchase the society would require an agreement to register the issue 
in accordance with the provisions of the Securities Act of 1933 in the 
event that it chose to resell the stock. 

Mr. Holmes replied that he would present Mr. Wendell's ofiFer to 
the executive committee for consideration, although he doubted whether 

^ Cf . Dixley Paper Company (A), p. 130. 

180 



DiXLEY Paper Company (B) 181 

it would be received favorably. For one thing, he did not believe that 
management would like to see the entire issue in the hands of one 
owner. Such concentration of ownership, making possible a unanimity 
of action which was seldom obtained when an issue was distributed 
among a large number of stockholders, was a potential source of trouble. 
Furthermore, public distribution would enhance the marketability of 
any future issues that might be contemplated by making the company 
better known to the investing public. Mr. Holmes was also impressed by 
unfavorable reports that he had received from friends who had done 
business with insurance companies. According to these friends, he told 
Mr. Wendell, insurance companies required quarterly balance sheets 
and earnings statements and frequently sent their economists and statis- 
ticians to inquire into company affairs. In many instances, these insur- 
ance company representatives had caused considerable irritation. 

Mr. Wendell conceded that there was truth in what Mr. Holmes 
said. Nevertheless, the society's proposal had a number of advantages 
which he thought ought to be considered. Among these were the fol- 
lowing: 

Closing of the transaction would take from two to three weeks as compared 
with two and a half or more months for a public issue, during which time the 
prospective underwriters could take advantage of changes in market conditions 
to ask for a revision of tentative terms or to withdraw altogether. 

Except in the unlikely event that the society would at some future time exer- 
cise its right to have the securities registered, there would be no registration ex- 
pense, which would normally amount to about $45,000, including underwriter's 
expenses to be borne by the company and cost of qualification under state blue- 
sky laws. 

Management would be saved the trouble of preparing a registration state- 
ment, which took much executive time even when the greater part of the work 
was done by legal counsel. Moreover, much information about the company and 
its finances would have to appear in the prospectus, and detailed income state- 
ments, balance sheets, and surplus reconciliations would become available to the 
public and competitors. [Currently, only dividend notices and abbreviated bal- 
ance sheets and income statements were published.} 

Having a single stockholder would be of advantage in the event that manage- 
ment would ever desire the preferred stockholders to assent to or approve a cor- 
porate act. Negotiating with a great number of small stockholders, some of whom 
oftentimes proved to be troublemakers, could be a great burden to management. 

Mr. Holmes listened to Mr. Wendell without comment, and then 
repeated his assurance that the offer would be presented to the executive 
committee and that Mr. Wendell would hear from him in the near 
future. 



VVVVVWVVVVVVVAVVVV\VVVVVVIVVVVVVVVVVWVVVVVVVVVWVVVVV^VVV^ 



Continental Casualty Company (A) 



IV\\vVVVVVVVVVVWVVVVVVA\VV\VVVVVWVAVWVVtVVWVVVV\/VVV\A\VVW^ 



The executives and directors of the Continental Casualty Company 
planned to obtain new capital by selling additional stock in the early 
spring of 1941. When the problem of pricing the issue arose, they faced 
the alternative whether to sell the stock through investment bankers 
for as high a price as possible or to give to the stockholders rights to buy 
shares at a lower price/ 

Incorporated in Indiana in 1897, the Continental Casualty Com- 
pany ranked fifth in volume of net premiums written during 1940 
among American stock casualty companies. It was primarily concerned 
with writing three general types of insurance: accident and health, casu- 
alty, and bonding, the most important of which was casualty. The rest 
of the company's interests were absorbed in the investment and manage- 
ment of over $35,000,000 of assets not immediately tied up in the 
insurance operations of the business and in the affairs of various subsidi- 
aries. For example, the company took an active part in the management 
of the Continental Assurance Company, by virtue of owning 36% of 
the latter's stock, which had about $280,000,000 of life insurance in 
force. 

The company's insurance business was transacted through the home 
office in Chicago and seven branch offices located in large cities in the 
United States and Canada. Approximately 8,700 contract agents had 
varying degrees of authority to bind the company. About 25,000 brokers, 
while not having authority to bind the company, had placed business 
with it. The company also had a number of supervising general agents 
under contract and special agents under salary, who covered territory 
not assigned to branch offices. The authority granted to the respective 
contract agents of the company depended upon the type of risk to be 

^ In some states the "stockholders' pre-emptive right" to subscribe to new shares before 
nonshareholders may buy them is protected by the corporation law. In others (including 
Indiana) the right is not so protected. 

182 



Continental Casualty Company (A) 183 

insured and the agents' experience. The underwriting departments of the 
company at its home office supervised the business written by its agents 
and kept it within the bounds of the company's underwriting policy. 

The actual and prospective growth of the company was the main 
reason for the decision of the directors to secure new funds. The volume 
of the business of the Continental Casualty Company was almost twice 
as great in 1940 as it had been in 1932. The period following 1935 had 
been one of particularly rapid growth for the company. For example, net 
premiums written increased from $16,019,986 in 1935 to $25,372,294 
in 1940, and total admitted assets from $24,761,689 to $40,097,449. 

The company had sold no capital stock since 1927. As is shown in 
Exhibit 1, however, the surplus of the company had been substantially 
increased through retention of a large percentage of annual income. 
Despite the increase in the capital through retention of earnings in the 
business, the management felt that a further increase in the capital ac- 
counts through the sale of common stock would put the company in a 
stronger financial position to carry the increasing liabilities that came 
with the larger volume of business. The addition of capital funds 
through the sale of stock, moreover, would make it possible for the 
company to pay out a larger percentage of future earnings in cash divi- 
dends. Because of the troubled international and political situation there 
was also some feeling among the directors that the market for common 
stock might become less favorable. 

Accordingly, the directors voted on February 5, 1941, to sell 
100,000 shares of $5.00 par common stock. At that time, all of the au- 
thorized shares of common stock, 400,000, were already outstanding. 
Therefore, a special meeting of the stockholders was called for March 
10, at which time the stockholders would be asked to approve a change 
in the articles of incorporation of the company so as to authorize the 
issuance of the additional 100,000 shares of stock. 

During 1940 the price of the company's stock, which was traded in 
the over-the-counter market, had ranged from a high of 38 bid (Febru- 
ary 7, 1940) to a low of 27 bid (May 21, 1940). During January, 
1941, the price range was from 34^ (January 9) to 34 (January 22). 
In February the stock had ranged from 34| (on February 6) to 31^ 
(on February 15 and 17). Since it was not expected that total earnings 
of the company would increase in proportion to the increase in the 
shares of common stock of the company, the new issue was expected to 
dilute earnings per share. The directors, nevertheless, thought that the 
new shares could be sold at prices close to the current market. 



184 Case Problems in Finance 

They planned to announce that it was their intention to pay about 
the same annual dividend per share as they had during the last three 
years, if the earnings of the company continued at substantially the level 
of those years. During 1939 and 1940 the company had paid a "regular" 
quarterly dividend of 30 cents a share and an 'extra" dividend of 30 
cents a share in the last quarter, making a total annual dividend of $1.50 
a share. In 1938 the "extra" dividend in the last quarter was 40 cents a 
share, making at total annual dividend for that year of $1.60 a share. 
In 1939 a stock dividend of 50,000 shares (one for each seven outstand- 
ing) had been paid. In Exhibit 1, the record of the company's annual 
earnings and dividends for the previous 10 years shows the company's 
dividend policy and other financial data. 

It was thought that an offering could be made successfully at ap- 
proximately $32 a share. However, some directors suggested the desira- 
bility of giving to stockholders rights to buy the offering at $25. Under 
such a procedure, each stockholder would obtain transferable "rights" 
to purchase his pro rata share of the new issue. A letter to the stock- 
holders, dated February 7, 1941, calling a meeting on March 10 to ap- 
prove the issue of stock, was phrased in such manner as to permit the 
later adoption of either of the two plans. 

Exhibit I 





CONTINENTAL 


CASUALTY C 


OMPANY 


(A) 








Selected Data 












(Dollar figures in thousands) 










Net 














Earnings 












Underwriting 


from 


Operating 


Federal 


Net 


Cash 


Year 


Profit* 


Investments 


Profit 


Taxes 


Income 


Dividends 


1931 


% 35ir 


$790 


% 439 


t 


$ 439 


$560 


1932 


6m^ 


662 


2A^ 


t 


24'' 


140 


1933 


673t' 


615 


58** 


t 


58'' 




1934 


123t' 


600 


477 


t 


477 


210 


1935 


121"^ 


e6A 


543 


$ 50 


493 


210 


1936 


454 


735 


1,189 


125 


1,064 


350 


1937 


1,049 


736 


1,785 


160 


-1,625 


525 


1938 


1,368 


647 


2,015 


270 


1,745 


560 


1939 


885 


829 


1,714 


265 


1,449 


585 


1940 


1,209 


864 


2,073 


375 


1,698 


600 



* Difference between income from insurance premiums and payments on policies plus expenses of the insurance 
phase of the business. 

t After federal taxes. In 1935 and subsequent years underwriting results are before federal taxes, 
d Deficit. 



|^,yyyyyYYyy,yyY\VVVV\VVVVV\\\VV\VWVV\AA\\VV\\VV^^ 



Continental Casualty Company (B) 



ivvvvvvvvvvvvvvv\vv\vwvvvvvv\\vvvvvvvwvvi\vvvvvv^^ 



In the spring of 1941 the directors of the Continental Casualty Com- 
pany were considering whether to sell a proposed new issue of capital 
stock in the open market or to distribute it by issuing rights to be given 
to the existing stockholders. 

After discussing the matter at some length, the directors voted to 
recommend a price of $25 and the use of rights to sell 100,000 shares. 
The decisive considerations leading to their recommendation were, first, 
that it would have a very beneficial effect on stockholder relationships, 
and, second, that the stockholders deserved consideration because of the 
conservative dividend policy followed in the past. 

At a meeting on March 10, the stockholders voted in favor of the 
proposed issue and authorized the directors, at their discretion, to take 
the necessary steps to carry out the decision before February 4, 1942. 

On March 24 the stockholders were informed that a registration 
statement and prospectus had been filed with the Securities and Ex- 
change Commission. Although rights were to be used, it had been de- 
cided to underwrite the issue. The agreement with the underwriters, of 
v/hom the principal members were Glore, Forgan & Co. and Blair, Bon- 
ner & Company, is set forth in following excerpts from the prospectus:^ 

The underwriting agreement provides that in consideration of the agree- 
ments of the several underwriters the Company shall pay to each Underwriter on 
the closing date (a) a sum determined by multiplying $62,500 by the percentage 
share of each Underwriter in the underwriting (b) in addition, if the several 
Underwriters shall become obligated to purchase in the aggregate on the closing 
date more than 10,000 shares but not more than 25,000 shares of the Capital 
Stock, the sum of $1 for each share of the Capital Stock which such Underwriter 
shall purchase, or, if the several Underwriters shall become obligated to purchase 



iPp. 1, 20-21. 

185; 



186 



Case Problems in Finance 



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Continental Casualty Company (B) 187 



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188 Case Problems in Finance 

in the aggregate on the closing date more than 25,000 shares of the Capital Stock, 
the sum of $1.50 for each share of the Capital Stock which such Underwriter 
shall purchase. 

The effect of this underwriting agreement was to assure the Con- 
tinental Casualty Company of the sale of its issue, with proceeds to the 
company of at least $2,287,500, or $22,875 per share. 

On April 2 subscription warrants or "rights" were mailed to stock- 
holders of record at the close of business that day "evidencing the right 
to subscribe for Capital Stock of the Company at the rate of one-fourth 
(i) share for each share held." The warrants expired at 5:00 p.m. cen- 
tral standard time, April 12. 

The record of the market of the stock from January through April, 
1941, is shown in Exhibit 1. Before the expiration date the stockholders 
subscribed for 94,159 shares, leaving 5,841 shares which were bought 
by the underwriters at $25, according to the agreement. The underwrit- 
ers received the minimum commission of $62,500 plus whatever profits 
they made by resale of the shares they purchased. These were sold at the 
market whenever the individual underwriters felt it desirable, but prob- 
ably the bulk were sold at a profit of about $4.00 a share. 



\VVVVVVV\VVVVVVVVVVVVVV\VVW^\\\VV\\VVVV\VVWVAAaVV\VlVVVVWV^^ 



Johns-Manville Corporation 



VVV>\VVVVVVVV\VIVVVWV\VVVUVVVVVVVVVVVVVVVVV\AVVVVVV\\VWVVWW 

The Johns-Manville Corporation announced on January 16, 1937, 
that it planned to issue 100,000 additional shares of common stock, 
without par value, and to make them available for subscription by hold- 
ers of common stock in the ratio of one new share for each seven and 
one-half shares held. It was expected that the subscription price would 
be $100 a share, which would provide the company with $10,000,000, 
less expenses. This money would provide working capital for the com- 
pany and its subsidiaries and enable them to enlarge manufacturing and 
operating facilities. 

In the prospectus it was estimated that net proceeds of the issue 
would amount to $9,651,320 after deducting estimated expenses of 
$198,680 and underwriting discounts. Although the net proceeds were 
not allocated to any specific uses, the corporation contemplated that ap- 
proximately $3,420,000 would be expended after January 1, 1937, for 
manufacturing, mining, and operating facilities; $1,300,000 would be 
used to increase the capital of Johns-Manville Credit Corporation, a sub- 
sidiary engaged in providing installment credit to dealers and con- 
tractors in connection with the sale of the corporation's products; and 
$5,000,000 would be used as working capital, of which about 
$3,500,000 would reimburse the treasury for expenditures for mining, 
manufacturing, and operating facilities made during 1936. 

The company had outstanding 75,000 shares of $100 par cumu- 
lative 7% preferred stock, of an authorized issue of 100,000 shares, 
and 750,000 shares of no-par common stock, of an authorized issue of 
1,000,000 shares. The proposed issue was to be part of the 250,000 
shares authorized but not issued. Balance sheets and a few financial sta- 
tistics of the corporation are shown in Exhibits 1 and 2. Prices of the 
common stock are given in Exhibits 2 and 3. 

^ The material in this case is from various published sources. 

189 



190 Case Problems in Finance 

In conformance with this plan the corporation filed a registration 
statement with the Securities and Exchange Commission and, when this 
registration became effective, offered to its common stockholders of 
record, at the close of business on February 19, 1937, pro rata rights 
to subscribe in the aggregate to 100,000 shares of additional common. 
Each such holder was offered, until 3:00 p.m. on March 11, 1937, the 
right to subscribe to two-fifteenths of one share at $100 a share for each 
share held. Transferable subscription warrants evidencing such rights 
were to be mailed to stockholders as soon as practicable after February 
19, 1937. Stock certificates were to be deliverable at the office of J. P. 
Morgan & Co., 23 Wall Street, New York, after the exercise of the 
warrants. 

The offering to stockholders was underwritten by eight investment 
houses, of which each had a 10% interest in the purchase of unsub- 
scribed stock except Morgan Stanley & Co., Incorporated, which had 
30%. These underwriters severally agreed to purchase, at $100 a share, 
according to the foregoing percentages, such of the 100,000 shares as 
were not subscribed for by the holders of subscription warrants. For this 
underwriting, the corporation was to pay the underwriters $150,000. 
The underwriting contract also provided that, if any underwriter should 
fail or refuse to purchase the percentage of unsubscribed stock which it 
was required under the contract to purchase, Morgan Stanley & Co., In- 
corporated, would purchase for its own account or find purchasers for 
such percentage of unsubscribed stock. 

There appeared in the Wall Street Journal for March 29, 1937, an 
account of the corporation's annual meeting which read, in part, as 
follows: 

Business of the Johns-Manville Corp. so far this year has been showing a 
substantial increase over the like 1936 period, President Lewis H. Brown told 
stockholders at their annual meeting Friday. . . . The increase in sales in the 
initial quarter of 1937, he added, was not due to stocking up by dealers, al- 
though advance buying by the trade was somewhat better than a year ago. . . . 

Commenting on 1936 business, Mr. Brown said that sales increased 
progressively as the year advanced, with a sharp acceleration being ex- 
perienced in the final months. He said that the price war in the asphalt 
materials field, which adversely affected Johns-Manville's showing in 
the initial quarter, terminated more quickly than had been anticipated. 
. . . For the entire year, sales totaled $48,922,01 1, yielding a net profit 
of $4,373,707, equivalent after preferred dividends to $5.13 a share on 
the then outstanding 750,000 shares of common stock. 



Johns-Manville Corporation 191 

All but 650 shares of the recent issue of 100,000 shares of Johns- 
Manville common stock were subscribed for by stockholders at $100 a 
share, Mr. Brown stated, in answer to a question by Col. B. F. Castle of 
the Administrative & Research Corporation, a stockholder. After stating 
that he did not see any set of circumstances that necessitated the ex- 
penses entailed in the underwriting of the issue. Col. Castle asked if Mr. 
Brown did not think the strong position of the company would have 
enabled it to have dispensed with that service. In reply Mr. Brown said 
that the underwriting was agreed upon only after lengthy consideration 
of the many factors involved. These, he said, included the troubled labor 
conditions in this country and the threat of a European war due to acute- 
ness of the Spanish situation at that time. Also, it was one of the first 
sales of a large issue of new stock by a major corporation since the de- 
pression. In view of all this and the relative moderateness of the fee 
(H%) in comparison to the amount involved, Mr. Brown said, "I 
made the decision and it was my best judgment and I am very well 
satisfied with the whole picture." 



192 Case Problems in Finance 

Exhibit 1 

JOHNS-MANVILLE CORPORATION 

Condensed Comparative Consolidated Balance Sheets 

(Dollar figures in thousands) 

ASSETS 

Dec. 31 Oct. 31 Dec. 31 

1933* 1936f 1936* 

Cash $ 4,061 I 4,092 $ 3,149 

Notes and accounts receivable, net 3,692 6,565 5,662 

Inventories 5,957 7,032 7,495 

$13,710 $17,689 $16,305 

Land, buildings, equipment, mineral properties, etc., net ... 21,218 22,094 22,565 

Investment and advances to J-M Credit Corp 2,400 1,300 1,200 

Miscellaneous 980 687 614 

$38,308 $41,770 $40,684 

LIABILITIES 

Accounts payable $ 1,115 $ 1,883 $ 1,817 

Accrued liabilities 551 1,463 933 

Reserve for income taxes 541 1,027 1,131 

Other current 506 100 131 

$ 2,712 $ 4,473 $ 4,013 

Reserves 723 743 758 

Minority interest in subsidiaries 60 67 64 

Preferred Stock, at liquidation value 9,000 9,000 9,000 

Common stock 15,000 15,000 15,000 

Initial surplus^ 6,683 6,683 6,683 

Earned surplus 4,131 5,804 5,167 

$38,308 $41,770 $40,684 

* Source: Poor's Industrials, 1937. 

t Source: Prospectus of February 15, 1937. 

t After deducting $1,500 transferred to capital account in order to carry preferred stock at liquidation value. 

Exhibit 2 

JOHNS-MANVILLE CORPORATION 

Selected Statistics* 

(Dollar figures in thousands) 

Common Stock 

Prices Net Dividends Net 

Years High Low Sales Earnings Preferred Common Worth 

1927 126i 55i $44,313 $4,108 $525 $2,250 $32,016 

1928 202 96i 47,910 5,589 525 2,250 34,830 

1929 2421 90 61,994 6,591 525 2,250 38,647 

1930 1481 481 49,492 3,268 525 " 2,250 39,140 

1931 801 151 33,481 583 525 1,875 37,324 

1932 331 10 20,409 2,680'' 525 34,118 

1933 65i 12i 21,232 105 393 .... 33,830 

1934 66i 39 27,300 749 656 .... 33,923 

1935 99i 38i 34,646 2,164 525 750 34,813 

1936 152 88 48,922 4,373 525 2,812 35,849 

♦ Source: J-M Stockholders' News, January, 1938; except for stock prices, which were taken from the Prospectus 
of February 15, 1937. 
^ Deficit. 



Johns-Manville Corporation 193 

Exhibit 3 

JOHNS-MANVILLE CORPORATION 

Common Stock and Subscription Warrant Prices 

Common Stock Subscription Warrants 

Low 



^EEKS Ending 


High 


Low High 


Dec. 4, 1936 


144 


139 




11 


143i 


141 




18 


I46i 


I43i 




25 


145 


I4li 




Jan. 1, 1937 


146i 


145 




8 


155 


im 




15 


155 


153 




22 


154i 


143 




29 


150 


143 




Feb. 5, 1937 


1471 


I44i 




12 


1471 


I44i 




19 


150 


146i 




Ex-Rights 








Feb. 19, 1937 


139 


136i 




26 


138i 


134i 51/16 


Mar. 5, 1937 


145i 


134 515/16 


12 


I48i 


140 6 


f 


20 


147 


141 




27 


I44i 


138i 





41 



5i 



k 



WAA\\^VVVVVVVVVlVVVViVVVVVV\Vl\V\A/VVVVV\VWVVVVVV%\VV^^ 



Pure Oil Company' 



AVVVV\VVVV\VVVVVVVVVVVVVVWVWIVVVVV\AA/WVVVVVVVAA\VV^^ 



On February 13, 1937, the directors of the Pure Oil Company, an 
Ohio corporation, decided that current conditions in the securities mar- 
kets were favorable to the sale by the company of a large issue of pre- 
ferred stock. It was planned to issue some 420,000 shares of $100 par 
preferred stock. The company currently had outstanding large issues of 
8% and 6% cumulative preferred stock, and the proposed issue would 
rank equally with the 8% and 6% issues as regards preference in divi- 
dends and assets. 

According to company officials, the proceeds of the proposed issue 
of new preferred stock would be used for four major purposes. The first 
was the retirement of the outstanding $7,662,000 of 8% preferred 
stock, which was callable at $110 a share plus accrued dividends on any 
dividend date provided 60 days' advance notice was given. 

The second major use for the new money was the retirement of an 
outstanding issue of 4^% notes. These notes had been sold to the 
public in 1935 through an underwriting syndicate of investment 
bankers headed by Edward B. Smith & Company. Nondetachable war- 
rents on each $1,000 note entitled the holder to purchase 30 shares of 
common stock, currently selling at a price of $ 1 5 a share. Through the 
use of funds obtained by the exercise of common stock purchase war- 
rants attached to the notes, the original issue of $32,000,000 had been 
reduced to $28,500,000 in February, 1937, and on February 10, 1937, 
$1,211,300 in cash was available for further retirement of these notes. 
The notes could be called on any interest date (January 1 and July 1 ) , 
provided 30 days' notice was given. 

It was also expected that some $4,000,000 of bank debt currently 
outstanding would be retired. Finally, the company desired to develop 
further its oil producing and refining properties. 

^ The material in this case is from various published sources. 

194 



Pure Oil Company 195 

At a special meeting held on March 26, 1937, the stockholders of 
the company voted to amend the articles of incorporation so as to author- 
ize the new issue of preferred stock. In addition, the number of author- 
ized common shares was increased from 4,000,000 to 10,000,000 
shares. 

On May 3, 1937, the company filed a registration statement with the 
Securities and Exchange Commission covering 469,454 shares of cumu- 
lative convertible preferred stock. It was planned that the new pre- 
ferred stock would be convertible into common shares and would be 
offered first to the common stockholders of the company as of May 28, 
1937. The new preferred would be offered at par ($100), and sub- 
scription rights would be good until June 18, 1937. The dividend rate 
on the new issue, as well as the rates at which the preferred stock could 
be converted into common stock, had not been announced. They were 
to be supplied later by amendment to the registration statement. It was 
expected that Edward B. Smith & Company would form a syndicate of 
investment bankers to purchase any shares not subscribed to by the 
common stockholders. 

In the meantime, in order that the company could safely announce 
the call on July 1 of the 4^% notes, the company on March 13 entered 
into a stand-by loan agreement with six large commercial banks. In ef- 
fect, the banks agreed, if called upon, to loan the company as much as 
$25,000,000 on June 29, 1937, the money to be used to redeem the 
4^ % notes. Under the agreement the bank loans would be repaid out of 
the proceeds of the sale of the new convertible preferred when and if 
such sale were accomplished. In any case, the bank loans were to be re- 
paid within three years. In return for the commitment to loan if neces- 
sary, the banks were paid $125,000 by the Pure Oil Company. 

In June, 1937, the company filed an amendment to the registration 
statement postponing the offering date of the new preferred stock to 
June 25, 1937. However, before June 25, the offering was again post- 
poned. On June 28, 1937, an official of the company stated: "The pro- 
posed financing which we have in contemplation has been delayed due 
to market conditions in this country. We are hopeful that the delay is 
only a temporary one." Prices for the principal Pure Oil securities as well 
as the Dow-Jones average of market prices of selected common stocks 
of industrial companies are given in tabular form in Exhibit 2 and 
graphically in Chart 1 (p. 200). 

On August 23, 1937, the president of the Pure Oil Company in a 
letter to common stockholders announced that the company would pro- 



196 Case Problems in Finance 

ceed with the offering of preferred stock. He stated that the directors had 
authorized the offering to common shareholders of record on September 
3, 1937, of the right to subscribe to 5% cumulative convertible pre- 
ferred stock at $100 per share. For every nine shares of common stock 
held, the common stockholder would receive rights to purchase one 
share of the new convertible preferred stock. The rights to subscribe to 
the preferred stock would expire on September 24, 1937. 

The initial conversion price on the new preferred was set by the 
board of directors at $22.22%. In other words, at any time up to Octo- 
ber 1, 1940, each preferred share could be converted into 4^ shares of 
common stock. After October 1, 1940, the rate of conversion changed 
to 4 for 1, and after October 1, 1942, to 3i for 1. The conversion 
privilege expired October, 1947. 

The stock purchase rights were transferable and arrangements were 
made to admit the rights to trading on the New York Stock Exchange. 

Underwriting of the issue was provided by a syndicate of 42 invest- 
ment banking houses headed by Edward B. Smith & Company; the 
latter house alone took 13i% of the commitment. In return for the 
underwriter's agreement to purchase all the preferred shares not taken 
up by the common stockholders, they received an underwriting fee 
of $2.50 per share, or a total of $1,106,107.50 on the maximum of 
442,443 preferred shares offered. 

On September 27, the company announced that stockholders had 
subscribed to 8,040 shares of the preferred stock. Thus 434,394 shares 
with a par value of $43,439,400 were left for purchase by the under- 
writers. On October 22, 1937, the 42 investment banking firms took, 
and paid the company for, the unsubscribed preferred shares. Thereupon, 
the company called its outstanding 8 % preferred shares for redemption 
on January 1, 1938; all of the company's bank loans were also paid off. 
Pure Oil's balance sheets as of April 30 and December 31, 1937, are 
shown in Exhibit 1. 

In the currently depressed and unsettled market ( see Exhibit 2 ) the 
underwriters decided not to offer the unsubscribed shares for public 
sale.^ Through joint agreement the underwriter's shares were thus held 
off the market until after March 9, 1938, when the agreement among 
the underwriters as to joint action in the sale of the securities terminated 

^ Their failure to make the shares available to the public resulted in the inability of 
short sellers of the stock to acquire stock for delivery against their open contracts. After 
considerable investigation and negotiation, the Committee on Securities of the New York 
Stock Exchange announced that Edward B. Smith & Co. would make up to 5,000 shares 
of the stock available at $100 a share flat on and after December 6 but not beyond 
December 9, 1937. It had been disclosed that members of the New York Stock Exchange 
had open contracts to buy 10,116 shares and to sell 9,339 shares. 



Pure Oil Company 



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Case Problems in Finance 

Chart 1 



PRICE RANGE OF PURE OIL COMMON AND 6% PREFERRED STOCKS AND 
DOW-JONES INDUSTRIAL STOCK AVERAGE BY MONTHS 



DOLLARS 

220 

200 

180 

160 

140 

120 

100 
90 
80 
70 
60 
50 

40 



[RATIO SCALE) 



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1938 



and each underwriting firm was free to dispose of its shares in such man- 
ner and at such prices as it might see fit. No agreement was made among 
the underwriters for a pubhc offering; each was to buy, sell, or hold the 
shares at its own discretion.^ 



^The Securities and Exchange Commission set a precedent in the supervision and 
regulation of trading in this instance by requiring full reports on the positions and transac- 
tions of the Pure Oil underwriters beginning March 10 and by ordering them to make no 
purchases of the stock at a price above 741, although the prices at which they might sell 
were not restricted. 



Northern Indiana Public Service 

Company 
Central Maine Power Company 

/VVVWVVV»\VVVVVVVk\VVV\AA^VVVVVWVVVVWWVA^VVVVVVVVV^^ 



[Editor's Note. — The following material consists of excerpts from two 
decisions of the Securities and Exchange Commission interpreting Rule U-50 
under the Public Utility Holding Company Act of 1935. Briefly, this rule requires 
that companies under the jurisdiction of this law shall normally arrange for com- 
petitive bidding as a part of the procedure of issuing securities. 

The decisions selected emphasize matters connected with established rela- 
tionships between investment bankers and issuers of securities.] 

NORTHERN INDIANA PUBLIC SERVICE COMPANY 
Decided May 5, 1944 

Northern Indiana Public Service Company (''Northern Indiana") 
has filed applications and declarations with respect to proposed trans- 
actions including, among other things, the issuance and sale of 220,078 
shares of new cumulative 5% dividend preferred stock, $100 par value, 
under the Public Utility Holding Company Act of 1935. Its application 
in this connection is filed under Section 6 (b) of the Act. Northern 
Indiana requests that the issue and sale be excepted from the competi- 
tive bidding requirements of Rule U-50. 

The sole problem with which we are concerned here is the requested 
exception of the proposed issue and sale from competitive bidding. A 
hearing was held after appropriate notice, a brief was filed by Northern 
Indiana on this question, and we heard oral argument thereon. . . . 

. . . The company proposes to call its existing preferred shares at 
their respective call prices and to issue an identical number of new pre- 
ferred shares, $100 par value, with a 5% cumulative dividend, offering 
them first in exchange for the old shares and selling the balance to un- 
derwriters for public distribution. . . . 

Northern Indiana believes it would be to the best interests of itself 
and its security holders to exchange as many of the new shares as pos- 

201 



202 Case Problems in Finance 

sible for old shares in the hands of existing holders, paying in cash the 
differential between the offering price of the new shares and the call 
price of the old. It believes that existing stockholders would be benefited 
tax-wise by such exchanges and estimates that the compensation it must 
pay to investment bankers for soliciting such exchanges would be less 
than the cost of selling the entire issue to the general public. These are 
among the reasons for its plan to make the offering initially to its exist- 
ing preferred stockholders, employing investment bankers to solicit ex- 
changes and to underwrite the unexchanged portion of the new issue. 
The company proposes to compensate the bankers on a sliding scale 
for exchange solicitation, contending that by this method savings result- 
ing from exchanges ( as distinguished from cash sales ) will be likely to 
accrue to it rather than to the underwriters. It has entered into a tenta- 
tive arrangement whereby Stone & Webster and Blodget, Inc., and Har- 
riman, Ripley & Co., Inc., would lead a large group of bankers which 
would be paid for soliciting exchanges, standing by during the exchange 
period, and purchasing for public distribution all shares not taken by 
existing stockholders in exchange for old shares. 

Under the proposed arrangement the bankers would receive com- 
pensation equal to {a) $1.00 as a stand-by charge for each of the 
220,078 new shares; plus (Z?) an amount varying from 50^ for each 
share exchanged (if not more than 110,000 shares) to 75^ for each 
share exchanged (if more than 198,000 shares); plus {c) an amount 
varying from $1.50 per share purchased by the underwriting group (if 
the aggregate number purchased is less than 22,000 shares) to $2.50 
per share purchased (if such aggregate is 110,000 shares or more). 

Thus, the minimum compensation, if all shares were exchanged, 
would be $1.75 per share, or a total of $385,136; and the maximum, 
if no shares were exchanged, would be $3.50 per share, or a total of 
$770,273. Northern Indiana estimates that about 80% of the new 
shares will be issued in exchange for the old. On this basis payments to 
the bankers would be slightly over $420,000, or $1.90 per share. 

As heretofore stated, the company requests an exception from the 
provisions of Rule U-50 requiring competitive bidding as a condition to 
the proposed security issue. We believe the request must be denied. 

We should make it clear first that we do not take issue with the 
company's view as to the desirability of the refinancing or with the 



Northern Indiana Public Service Company 203 

method of exchange as the means of achieving it. Nor do we necessarily 
disapprove the principle of compensating underwriters on a sliding scale. 

However, the grounds for the company's preference for private ne- 
gotiation do not appear to us to be sufficiently persuasive to justify the 
granting of an exception; and the method through which the under- 
writers were selected and their compensation arrived at, and by which 
the public offering price is to be set, is subject to objections of a kind that 
formed a substantial part of the basis for our adoption of the competitive 
bidding rule. 

As we have noted. Northern Indiana regards a large volume of ex- 
changes as desirable because the financing is expected to be cheaper by 
that method. It also desires to retain as many of the present preferred 
stockholders as possible. It regards the sliding scale of compensation as 
an incentive to the underwriters to procure as many exchanges as pos- 
sible in preference to direct sales and as a method of retaining for itself 
a portion of the savings in financing costs which would result from a 
large volume of exchanges. 

Assuming a sliding scale of compensation, varying with the number 
of exchanges accomplished, the company contends that competitive bid- 
ding is not feasible since bids might vary at the several levels in the 
scale, one bid being more favorable for a certain number of exchanges, a 
second bid for a different number of exchanges, a third for still another 
number of exchanges, and so on. This, the company asserts, would ren- 
der it impossible to pick the best bid. 

As an alternative, our staff advanced the tentative suggestion that 
bids be solicited specifying {a) the public offering price for the new 5 % 
preferred and ( ^ ) a lump sum to compensate the underwriters for the 
over-all job of soliciting exchanges, standing by, and underwriting 
shares not exchanged. This suggestion contemplated that the underwrit- 
ers would be permitted to begin selling the stock during the exchange 
period subject to the stockholders' prior right of exchange. 

While some of the grounds offered by the company may possess a 
certain validity, they are not, in our opinion, sufficiently cogent to justify 
concluding the matter in favor of an exception from the rule. In the first 
place it is by no means certain that compensation on a sliding scale offers 
the expected inducement to underwriters to effect exchanges in prefer- 
ence to sales; nor is it necessarily true that, if bids were made competi- 



204 Case Problems in Finance 

tively on a sliding scale, differences in the bids at varying levels of the 
volume of stock exchanged would be such as to preclude the seleaion 
of the best bid from among them. It is entirely possible that one bid may 
be superior to the rest in .all levels, or at least for the volume of ex- 
changes that the company considers within the range of probability. The 
selection of the best bid by the company need not be a purely mechanical 
matter. The company has its own estimate of the probable volume of 
exchanges. Dean H. Mitchell, the company's president, testified that he 
thought at least 80% of the outstanding shares would be exchanged for 
the new stock. Even with bids on a sliding scale the company would be 
well within its rights in attaching weight to the bid that seemed most 
favorable to it at the level of exchanges which it anticipates, and discard- 
ing other bids even though they appeared more favorable at other 
levels. 

The remainder of the company's arguments — that the compensation 
is fair and reasonable, that the price for the unexchanged shares is ex- 
pected to be adequate, that the officers have exercised their best business 
judgment, and that experts have been consulted — are not peculiar to the 
situation presented by this exchange program. They are the familiar ar- 
guments advanced in opposition to the general principle of competitive 
bidding embodied in Rule U-50. In adopting the rule we pointed out 
that bids on a competitive basis are in general likely to be of substantial 
aid in determining whether or not the price and other terms of the issue 
are fair and reasonable, and our adoption of the rule was in part for the 
very purpose of affording assistance in the determination of such ques- 
tions. The company's contentions in this respect cannot, therefore, serve 
as a basis for an exception from the rule in the absence of extraordinary 
circumstances. 

We turn now to an examination of the negotiations [as conducted}. 

The exchange program coupled with a stand-by underwriting agree- 
ment has, according to Mitchell's testimony, been contemplated for 
several years, during which discussions were held at intervals with Harri- 
man, Ripley & Co., Inc., and with Stone & Webster and Blodget, Inc. 
During the summer of 1943 discussions with Harriman, Ripley & Co. 
were resumed and the transaction was given considerable study, but cer- 
tain provisions of the tax law, since amended, made it inadvisable to re- 
finance at the time. In October, 1943, Stone & Webster and Blodget 



Northern Indiana Public Service Company 205 

expressed an interest in formulating a refinancing plan, but still no defi- 
nite proposal was evolved. 

Early in 1944 the company became convinced that from a market 
viewpoint it was feasible to proceed with the transaction, and active dis- 
cussions were again held with both financial houses. On February 2, 
1944, Harriman, Ripley & Co. furnished the company with a tentative 
schedule of fees for the refinancing program. Despite the fact that this 
schedule was only tentative and that no schedule at all had been sub- 
mitted by Stone & Webster and Blodget, the company early in March, 
1944, orally advised the two houses that they would be jointly engaged 
as exchange solicitors and underwriters, with 75% of the issue going to 
Stone & Webster and Blodget and 25% to Harriman, Ripley & Co. 

On April 5, 1944, the present application-declaration was filed. On 
April 13, 1944, a conference was held between the company and Harri- 
man, Ripley & Co., Inc., and Stone & Webster and Blodget, Inc. This 
was the first meeting of the company with the two houses since it in- 
formed them that they were jointly awarded the refinancing. At this 
conference, Harriman, Ripley & Co. withdrew the tentative schedule of 
fees it had submitted on February 2, 1944, asserting that market condi- 
tions for preferred stocks had changed, and the two underwriting firms 
then submitted a new schedule of fees covering their compensation. The 
schedule had been arrived at without the participation of the company 
and was somewhat higher than the prior tentative offer submitted by 
Harriman, Ripley & Co. It was approved by the company and is em- 
bodied in the filing before us. Up to April 28, 1944, when oral argu- 
ment was held before us, the price the underwriters would offer for the 
unexchanged shares and the length of time for the exchange offer, were 
undetermined. 

An oral understanding exists between the company and Harriman, 
Ripley & Co. and Stone & Webster and Blodget that, if the present ap- 
plication for an exception from Rule U-50 is denied and the issue is held 
subject to competitive bidding, the two firms will be paid for services 
already rendered and expenses incurred in an amount not to exceed 
$20,000. 

An exhibit introduced in the record contains a tentative list of 70 
underwriters assembled by Stone & Webster and Blodget and Harriman, 
Ripley & Co. With few exceptions, practically every underwriting house 
of importance is included in the list. 



206 Case Problems in Finance 

It thus appears that the company made its selection of underwriters 
without definite knowledge of the terms they would offer. It appears 
further that the possibility of submitting the refinancing to competitive 
bidding was summarily dismissed by the company. Mitchell testified that 
he did not know how competitive bidding could be effected with an ex- 
change offer and that both of the designated underwriting houses told 
him, in response to his question on the subject, that competitive bidding 
was not feasible. Our staff is available for consultation on financing pro- 
posals and for the expression of its opinion on the appropriateness of 
applying for an exemption from competitive bidding in a security flota- 
tion. Its views were not sought. The decision to request the exemption 
was that of the company alone, and the only outside advice it had was 
not disinterested. 

We may note that in 1942 we rejected a similar request by the 
Public Service Company of Indiana, which, like the applicant, is a com- 
pany in the Midland United system, with respect to a proposed issue of 
bonds under circumstances of which the present application is reminis- 
cent. In Public Service Company of Indiana we said: 

''Our competitive bidding rule applies, and was intended to apply 
to all such securities and to preferred and common stocks as well. In- 
deed, there is usually more reason for resorting to competitive bidding 
in the case of securities below the high grade bond level because it is 
normally more difficult to ascertain a fair and adequate price for them. 
The range of fluctuation is greater for such securities. Competitive bid- 
ding — with all prospective purchasers given an opportunity to buy the 
proposed securities — insures that the most equitable price will be ob- 
tained. 

"We must also reject the suggestion that an exception from our 
competitive bidding requirements should be granted because there is a 
possibility that bidding may result in a lower price than can be obtained 
under the present commitment. True, such a possibility exists but there 
is, at the least, an equal possibility that the bonds may be sold at higher 
prices through competitive bidding. If such an argument were permitted 
to be persuasive, the competitive bidding rule could be completely nulli- 
fied in every case where, notwithstanding our Rule, a company enters 
into a private contract for the sale of securities and, thereafter, petitions 
for an exception to the Rule. Furthermore, this argument ignores the 
fact that our competitive bidding rule is also designed to assure the 



Northern Indiana Public Service Company 207 

maintenance of competitive conditions and to eliminate any possibility 
that affiliated underwriters or other purchasers will monopolize the dis- 
tribution or purchase of securities or will obtain them on more favorable 
terms than others. . . . 

"In promulgating the Rule, we obviously did not intend that excep- 
tions from it would be lightly granted; an issuer, therefore, cannot act 
on the assumption that no attempt need be made to comply with its gen- 
eral requirements. ... It appears to us that the company unwarrant- 
ably assumed that it could disregard the competitive bidding rule and 
make such full arrangements for the private sale of its securities that the 
Commission would be compelled to grant its application for an excep- 
tion or else face the onus of delaying the issue. We cannot permit our- 
selves to be jockeyed into such a position. ..." 

An appropriate order will issue denying the request for exception 
from Rule U-50. 

By the Commission (Commissioners Healy, Pike, and McCon- 
naughey), Chairman Purcell not participating, and Commissioner 
O'Brien filing a dissenting opinion. 

CENTRAL MAINE POWER COMPANY 
Decided February 2, 1949 

Central Maine Power Company ("Central Maine"), a Maine cor- 
poration, has filed an amended application pursuant to Section 6 (b) of 
the Public Utility Holding Company Act of 1935 and Rule U-50 there- 
under with respect to a proposed issue and sale of 286,496 shares of its 
common stock. . . . The application requests that the proposed trans- 
action be exempted from the provisions of Sections 6 (a) and 7 of the 
Act and from the competitive bidding requirements of Rule U-50. 

After appropriate notice a public hearing was held. We have con- 
sidered the record and upon the basis thereof make the following find- 
ings: 

Central Maine proposes to issue and sell for cash up to 286,496 
shares of its common stock, $10 par value, the net proceeds to be ap- 
plied to the reduction of the company's short-term bank loans made in 
connection with its current construction program. 

The common stockholders and the 6% preferred stockholders of 
the company have pre-emptive rights to subscribe to the new common 
stock. NEPSCO, owner of 77.8% of the common stock of Central 



208 Case Problems in Finance 

Maine, has advised the company that it will waive its pre-emptive rights 
in the new issue, amounting to 219,196 shares of the new common 
stock. The company proposes to offer the remaining 67,300 shares to its 
other common stockholders and to its 6% preferred stockholders for 
subscription, pursuant to their pre-emptive rights, as follows: One-sixth 
of a share of common stock for each share of common stock presently 
held and five-sixths of a share of common stock for each share of 6% 
preferred stock. Negotiable subscription warrants will be issued evidenc- 
ing such rights. Fractional shares of stock will not be issued. The sub- 
scription period will be from 10 to 13 days. 

The company proposes to sell the entire issue, subject to pre-emptive 
rights, to an underwriter. By reason of NEPSCO's waiver of its pre- 
emptive rights with respect to 219,196 shares of the proposed issue, the 
underwriter will be in a position to offer such shares for sale to the pub- 
lic without waiting for the expiration of the subscription period. It is 
proposed that the price at which the stock is offered for subscription by 
stockholders will be the same as the price to the public. The company 
proposes to select an underwriter after negotiations with three or more 
investment bankers and in this connection requests an exemption from 
the competitive bidding requirements of Rule U-50. 

In support of its application for exemption from the competitive 
bidding requirements of Rule U-50, Central Maine cities, among other 
things, its unsuccessful attempt to sell common stock at competitive 
bidding in December, 1947. At that time the stock was quoted at $17 a 
share and it was understood that a number of groups were planning to 
bid. However, only one bid was received, at a price to the company of 
$12 a share. This bid was rejected by the company. It appears that one 
of the reasons for the lack of underwriter interest at that time was the 
fact that the company was experiencing severe drought conditions. 
These conditions substantially reduced the amount of energy generated 
in the company's hydroelectric plants and accordingly increased its op- 
erating costs. The company claims that since that time its earnings record 
has not clarified sufficiently to warrant an offer at competitive bidding, 
in the light of its prior experience in December, 1947. The drought ex- 
perienced in the last five months of 1947 continued throughout the first 
three months of 1948, and another period of drought was experienced 
from the end of June until early October, 1948. While, beginning in 
July, 1948, the company obtained rate increases estimated on the basis 



Northern Indiana Public Service Company 209 

of 1947 sales to produce approximately $1,500,000 of revenues annu- 
ally, and while it appears that water conditions in the last quarter of 
1948 have been substantially normal, the company emphasizes that such 
favorable factors are only partially reflected in its income statement for 
the year ended December 31, 1948, which necessarily reflects the ad- 
verse condition prevailing for the first half of the year. 

On the basis of the unsuccessful bid and the attendant circumstances, 
we feel that the company has made out a case for exemption from com- 
petitive bidding. However, the company's relationships and its activities, 
prior to the filing of the instant amended application, with the invest- 
ment banking firm of Coflin & Burr, Inc., have raised serious questions 
whether competitive conditions could be maintained if an unconditional 
exemption from competitive bidding was granted. In its original appli- 
cation filed in this proceeding in October, 1948, Central Maine proposed 
to issue and sell 303,330 shares of common stock. The company pro- 
posed to negotiate solely with Coffin & Burr for the underwriting of the 
offering and requested an exemption from the competitive bidding re- 
quirements of Rule U-50 for that purpose. It appears that CoflEin & Burr 
has acted as a principal investment banker and financial adviser for 
Central Maine for over 25 years and may properly be characterized as 
Central Maine's customary or historical banker. 

The record in this case shows that prior to the hearing on the origi- 
nal application and prior to securing authorization, formal or otherwise, 
to enter into a negotiated transaction, the company entered into detailed 
negotiations with Coflin & Burr as to the terms of the proposed under- 
writing. The record also shows that while the original application was 
pending the company conducted field trips to permit underwriters, deal- 
ers, and institutional investors to inspect its plant and territory. The in- 
vitations to participate in such trips were issued in each case by Coffin & 
Burr pursuant to an arrangement with the company. These negotiations 
and activities were inconsistent with the policy announced by us in the 
New England Gas and Electric Association case decided in January, 
1948 [where it was said} : 

"We now announce that it shall hereafter be our policy to deny 
summarily any application for exemption from the competitive bidding 
requirements of Rule U-50 where competitive bidding is prima facie 
required and the applicant has, before obtaining an authorization from 
this Commission, entered into any discussions or any negotiations with 



210 Case Problems in Finance 

respect to the terms of sale with any prospective purchaser of its secu- 
rities." 

After the hearing on the original application at which the above 
facts were made a matter of record but before the issuance of an order 
thereon, an amendment was filed. This second proposal eliminated the 
underwriting of the offering, but proposed that dealers be paid a fee for 
soliciting subscriptions from stockholders at a price to be fixed by the 
company and that a firm to act as manager of the solicitation be selected 
by the company on the basis of information received in response to writ- 
ten requests mailed to six investment bankers. Despite the risk free char- 
acter of the transaction and the substantial compensation involved, only 
Coffin & Burr offered to act as manager of the solicitation program for 
the stock. Prior to a hearing on this second proposal, but after discussions 
with our staff, the application was further amended to the form pres- 
ently before us. The record developed at the hearing on the present pro- 
posal shows that the company represents that it will negotiate with five 
investment bankers, of which Coffin & Burr is not one. 

Considering the history of this case as outlined above, we doubt 
whether competitive conditions could be maintained if the company in- 
tended to include Coffin & Burr among the underwriters with whom it 
proposed to negotiate. Upon the assumption that the company does not 
deal with Coffin & Burr as an underwriter in the proposed transaction 
and that competitive conditions are otherwise maintained, we are of the 
opinion, giving weight to the fact that the company's last attempt to sell 
common stock at competitive bidding was unsuccessful and in the light 
of its history and earnings' record since that time, that the proposed 
transaction falls within the conditions for exemption from Rule U-50 
specified in paragraph ( a ) ( 5 ) thereof, and that the requested exemp- 
tion should therefore be granted. 

. . . Therefore, in accordance with the provisions of the third sen- 
tence of Section 6 ( b ) of the Act, we shall exempt the issue and sale of 
such stock by the applicant from the provisions of Section 6 ( a ) , sub- 
ject, however, to the terms and conditions prescribed in Rule U-24 and 
to the following additional terms and conditions which we deem appro- 
priate in the public interest and for the protection of investors or con- 
sumers: 



Northern Indiana Public Service Company 211 

1. That the proposed issuance and sale of common stock by Central 
Maine shall not be consummated until the results of negotiations with 
prospective underwriters, the price at which the stock is proposed to be 
sold, the fees or commissions proposed to be paid to underwriters, and 
the final order of the Public Utilities Commission of Maine with respect 
to the proposed transaction have been made a matter of record in these 
proceedings and a further order shall have been entered by the Commis- 
sion in the light of the record so completed, which order may contain 
further terms and conditions as may then be deemed appropriate, juris- 
diction being reserved for such purpose; and 

2. That jurisdiction be reserved with regard to the payment of all 
other fees and expenses incurred or to be incurred in connection with 
the proposed transactions. 



AVVVVVVVVWVVVVVVV\VVWVVVVVVVVVVVVVVWVVWVVA\\^VV\VV\VWVV\V^^ 



McKellar Automatic Machine Company 



AVV\VWVVVV\VVVVVVl\\VWVVWVlVVVl\VVVWW\\\VVVVVVVVVVVWV^ 



In the fall of 1947, Mr. Clyde Webb, assistant to the president of 
McKellar Automatic Machine Company, was requested to investigate 
whether or not the company should list either its common or its pre- 
ferred stock, or both, on the New York Curb Exchange. Currently both 
issues were unlisted. 

The McKellar Automatic Machine Company had been organized in 
Massachusetts in the 1890's and until 1946 was closely held by two 
family groups. In early 1946, in anticipation of a public offering, the 
par value of the common shares was reduced from $100 to $5 per 
share and the number of authorized shares increased from 25,000 to 
1,000,000. New common shares were exchanged for old on the basis 
of 15 new for one old, or 18,750 old shares for 281,250 new shares, 
creating a paid-in surplus and leaving 718,750 shares authorized but 
not outstanding. 

Shortly after this recapitalization, in March, 1946, the company sold 
87,500 new common shares, and as a part of the same offering one of 
the family interests sold 49,250 shares, making a total of 136,750 shares 
sold to the public through the New York investment house of Fisher, 
Newton & Company. The price to the public was $8.00, and net pro- 
ceeds to the company were $7.25 per share. 

One year later, in March, 1947, through the same dealer, the com- 
pany sold 125,000 shares, 5% cumulative preferred, convertible share 
for share into common, $15 par, at $16.50 per share. The net proceeds 
to the company of $15 per share, or $1,875,000, were used for expan- 
sion of fixed assets and working capital. 

Thus, during 1946 and 1947, 261,750 shares of the company's pre- 
ferred and common stock had been sold. Most of these shares had come 
into the hands of investors who had previously had no interest in the 
company. 

212 



McKellar Automatic Machine Company 213 

From time to time during 1947, Mr. Edward Harlow, president of 
McKellar Automatic Machine Company, received letters from stock 
brokers in New York urging him to list McKellar's stock on the New 
York Curb Exchange. In February, 1948, he also received a statement 
(Appendix 1 [p. 220]) from an official of the New York Curb Ex- 
change which gave that organization's statement of the advantages of 
listing on the Curb. 

These communications prompted Mr. Harlow to ask his assistant, 
Mr. Clyde Webb, to investigate the proposal fully. Mr. Harlow ex- 
plained that, while no immediate expansion of the company was con- 
templated, the directors were agreed that the company should be ready 
to acquire any complementary concern if the opportunity should arise. 
Mr. Harlow thought that any such expansion would probably be 
financed by selling common stock to the public. He thought that such 
financing would be easier if the present shares were widely distributed 
and had a wide market following. As one consideration in the matter, 
therefore, Mr. Harlow wanted Mr. Webb to investigate whether listing 
would increase the ease of selling additional shares. 

Mr. Harlow reminded Mr. Webb that the controlling interests had 
no desire to liquidate their holdings further in the near future but that 
this aspect of the matter deserved consideration as a long-run possibility. 

Mr. Harlow had found that the initial cost of listing for McKellar 
would be $3,500. Most of this sum would be used to prepare for the 
SEC the registration statement necessary before listing. Since a similar 
registration statement had recently been prepared in connection with 
the issues of stock, the work would not be difficult and there could be no 
question of releasing information not previously made public. 

Mr. Webb, feeling that there were probably many aspects of this 
problem of which he was not aware, made arrangements to interview 
men connected with the securities business in New York. 

The first man he interviewed was Mr. Ernest Kilman of the firm of 
Kilman, Luther & Pringle, prominent over-the-counter dealers. Mr. 
Webb came to the conclusion that Mr. Kilman favored listing only for 
those securities which were widely distributed and were often bought 
and sold. On the other hand, when he interviewed Mr. Cameron, an offi- 
cial of the New York Curb Exchange, he received a much different 
opinion on the subject. He was referred to a number of other people, 
one of whom was a Mr. Doherty, an investment supervisor for a large 
trust company. Here he received still another viewpoint toward listed 



214 



Case Problems in Finance 

Exhibit 1 



NEW YORK CURB EXCHANGE 



LISTING FORM K 

( 10-10-45) 



DISTRIBUTION OF STOCK 
(Separate form to be made out £or each class of stock applied for) 



McKET.I.AR..AIJm)MATIG..JMAf:FrNE-COMEAmf:.... 

(Name of Company) 

Distribution of Cpnmon _ 

(CUss) 

Sejptember 11 194...Z... 



Stock 



I, Ed>rard Harlow _ Ere.sident , of 

(Name) (Title) 

..McKe.lI.aE..Aut;sfflatic..JMa.c.hlae...Company. , hereby certify that of the 2.65.^75.0 

(Company) (Amount) 

outstanding shares of 9.9!^9J}. stock of the -.McKell^.. Automat.ic..MacMn^^ 

(Class) (Company) 

there are U.9.,h.S^. shares held by the Public, exclusive of Officers, Directors, and Under- 

(See Note A Below) 

writers, which publicly held shares are distributed among 9.9.3. stockholders, and not 

(Number) 

pooled, in escrow, non-transferable or restricted as to sale in any manner whatsoever. 

Note A — The ten highest holders of the VJ.9.s±'^. shares certified above as publicly held, 

(Amount) 

are as follows : 



1, .?5l?...?.?.'f^?.o?l...QQ.i-. 

(Name) 



..2,981.... shares 6. ..j:a?ob..Ki.nS 

(Name) 



2. .?.?...?.!....'!^?*.? .2.1.9P.6... " 

(Name) 

3 Ernest T. Baxter .?.».5.9.0_.. " 

(Name) 

4, Etama Ford ?.^5p()... « 

(Name) 

5 Robert E. Hanna 2, 250 

(Name) 



J2,.05». shares 

7. ..??.r.9.y...?..«-.-.'!!?.9.1^y.I?- h.^1 " 

(Name) 

g Stanley Rhodes '^f^l.f. " 

(Name) 

Q Isaac Norwalk •'•/^T.? " 

(Name) 

Q**Rice & Co. 1,875 

(Name) 



The 



.iL8.9.»-25.v. share difference (t. e., difference between outstanding amount and 



amount certified above as publicly distributed) is held by ~ stockholders as follows : 

(Number) 

(SI10W below holdings of officers, directors, underwriter 
any outstanding sliarcs which arc restricted as to sale, and in 
inclusion of such holdings in this groupng.) 





Official Relationship 




Name 


to Company 


Holdings 


Karl Harlow 


Chairman, Board of Directors 


119,095 


Edward Harlow 


President and Director 


15,21^5 


Eric Phelps 


Treasurer and Director 


2,706 


D. R. Logan 


Clerk and Director 


1,069 


Percy Sandler 


Director 


125 


Dale Harlow 




1,187 


Alfred Shaw 


Vice President 


25,000 


Mervln McMillan 


Director 


2,062 


Gordon F. Walker 


Director 


5,219 


Charles C. Lloyd 


Director 


562 


Drew King 


Vice President and Director 


937 


Rudolph Howe 


Director 


3,862 


Raymond Hobbs 


General Partner, Fisher, Newton 






and Company 


1,312 


Charles F. Grace 


General Partner and Director, 






Fisher, Newton and Company 


•2,625 


Treasury Shares 




1891256 



♦Fisher, Newton & Co. owned of record but not beneficially 23,956 shares 
♦♦Investment dealers 



(See Other side) 



McKellar Automatic Machine Company 

Exhibit 1 — Continued 



215 



NEW YORK CURB EXCHANGE 


LISTING FORM K 1 


DISTRIBUTION OF STOCK 


(Separate form to be made out for each class of stock applied for) 


McKELLAR 


.^]!^]^'^I^...}^9^J^..!?SM.^. _... 




Common . Stock 


on f;ppt.Riii>if.r 11 


, 194-7. 




Shaies 


272 Holders of 


1 - 99 share lots - - - ?:!tj.5.66 _. „ 


3lo _ " .. 


100 " " - - - j>^.^m. _ _ 


206 " 


101 - 200 " « - - - .32^.560 _ 


62 „ .. 


201- - 300. " " _ - - .1.M5.6 . 


26 .. " 


301 - 400 " " - - - .8jtl6?.„ 


?3 " " 


401 - 500 " •• - - - 19..i.25 

<.m _ inm «' " _ - _ 21,900 


26 „ ., 


22 " .. 


,001 - up " " 232^^1 _ _ 


97T Stockholders 


Total Shares 3.68.,.75.Q * 


*This figure should be the total of all outstanding shares. 1 


Is any of the 


stnrW nonleH f1pr>n<:itPf? tn pcrrnw nnn-transfprahlp or hrXA 1 


(Class) r . r . 1 

under any syndicate, agreement or control ? 1 


If so, state the niunber of shares 
certified copies of all agreements relatii 


, and attach detailed explanation, including 


ig thereto. 




Certified Correct, 








(SEE OTHER SIDE) 



216 



Case Problems in Finance 

Exhibit 2 



NEW YORK CURB EXCHANGE 
lU S-4S 



DISTRIBUTION OF STOCK 
(Separate form to be made out for each class of stock applied for) 



Distribution of 

MarcbL.^5... 



(Name of Company) 

„ Preferred _ 

(CUm) 

, 1948 



Stock 



I, .E^wftrA..Iariow Freaidant. of 

(Name) (Title) 

...KcKellar„AutQrnftt;l?...Ma!;illBLe...C.Qiniiany , hereby certify that of the 125.^0CiO. 

(Company) (Amount) 

outstanding shares of preCerx&d stock of the ■McjKellax..Aul:.Qmatic...Mach.j.ng...C.cmipaay 

(Class) (Company) 



there are 125.,.QQ.Q 

(See Note A Bdow) 



shares held by the Public, exclusive of Officers, Directors, and Under- 
writers, which publicly held shares are distributed among .?.3... stockholders, and not 

(Number) 

pooled, in escrow, non-transferable or restricted as to sale in any manner whatsoever. 



Note A — The ten highest holders of the , 
are as follows: 

1. *P.Sb.er..&..C.Q.. 2^.50Q shares 

(Name) 

2. .../^??^^®^?..M.??...??.?.*..^9.r.?:ji.?.I5. " 

(Name) 

3. *Punn..&..La.jtpn ...I^5.Q0. " 

(Name) 

4 *B. A. Parker & Co. 1;.500 

(Name) 



5. *RlMle,.. Sendler .&.. Co ....1^3.L3_. 

(Name) 



.125.,000., 

(Amount) 



shares certified above as publicly held 



6. ....Ge.ox6e..H»..BenijnijQg... 

(Name) 

y Edna P. prls(:oll 

(N^liiJ) 

g M. I. Gushing 

(Name) 



9. ...BvelYn. Brady. 

(Name) " 

10_ _*Foster McMillan & Co, 1,070 

(Name) 



..1,.25.0. shares 

.i.250 " 

1,250 



lj2iQ.. 



The _ -V. share difference (». e., difference between outstanding amount and 

amount certified above as publicly distributed) is held by stockholders as follows : 

^ ' ' ' (Number) 

(Show below holdings of olTiccrs, directors, underwriters or others ir\ the "non-public" category. Also include below 
any outstanding shares which are restricted as to sale, and in center column state that such restriction is the reason for the 
inclusion of such lioldings in this groupng.) 

Official Relationship 
Name '" Company Holdings 



Certified Correct, 



♦Investment dealers 



By 

(SEE OTHER SIDE) 



McKellar Automatic Machine Company 

Exhibit 2 — Continued 



217 



NEW YORK CURB EXCHANGE 



LISTING FORM K 



DISTRIBUTION OF STOCK 
(Separate {orm to be made out for each class of stock applied for) 



McKELLAR AUTOMATIC MACHINE COMPANY 



Distribution of 


.Er.er.err.ed. 











.... Stock 


on-> March.25 




194..?. 






Shares 




.a93 Holde 


rs of 


I 


- 99 share lots - - - .. 
100 " "___.. 


21^076 




302 


3.Q..200... 




136 


., 


101 


- 200 


„ 


„ 


2U,882 




65 " 


" 


201 
301 


- 300 

- 400 


" 


<• .. 


.17^.232_.. 




10 


1.^331... 




9 


" 


401 
501 
1001 


- 500 

- 1000 

- up 


" 


" - - - • 


U,3T5 




13 


12^560 




6 .. 


..ii..'t38.._ 





Total Shares 1?.5,000_ 



i.?.!t -....Stockholders 

* This figure should be the total of all outstanding shares. 

Is any of the stock pooled, deposited m escrow, non-transferable or held 

(Class) 

under any syndicate, agreement or control ? 

If so, state the number of shares , and attach detailed explanation, including 

certified copies of all agreements relating thereto. 

Certified Correct, 



(SEE OTHER SIDE) 



218 Case Problems in Finance 

and unlisted securities. Mr. Webb's notes on these interviews are found 
in Appendix 2 (p. 222). 

After the trip, Mr. Webb realized that he should make a careful 
study of the ownership of the company's shares. Accordingly, Mr. Webb 
asked the transfer agents^ for the securities for lists of common and pre- 
ferred shareholders. After receiving the lists he had them summarized. 
Exhibits 1 and 2 follow the forms provided by the New York Curb Ex- 
change to accompany a listing application. Exhibit 3 presents certain in- 
formation graphically. 

Mr. Webb knew that he should have some indication of the number 
of purchase and sale transactions taking place. He did not wish to secure 
this information from the dealers who were making a market in the 

Table 1 

McKELLAR AUTOMATIC MACHINE COMPANY 

Number of Stock Transfers Recorded with Transfer Agents from September 

11, 1947, TO April 1, 1948 

Common Preferred 

First National Commercial Bank 278 28 

National Industrial Development Bank 309 135 

587 163 

stocks because he felt that they might hesitate to giYC information which 
might indicate a case for listing. Therefore, he asked the transfer agents 
for the number of transactions that had been recorded in each class of 
stock over the last few months. He realized that such data did not give a 
true picture because it did not reveal the amount of activity accom- 
plished through "street certificates,"^ but the results would be reasonably 
approximate as dividends were being paid on both the common and pre- 
ferred shares. The figures appear in Table 1. 

^ A "transfer agent" is an agency employed to maintain the record of stockholders* 
names and addresses and to make transfers from one name to another upon receipt of 
proper orders. 

^ A "street certificate" is a stock certificate that is so registered that it can be bought 
and sold without reference to the transfer agent. 



McKellar Automatic Machine Company 



219 



a. 




220 Case Problems in Finance 

APPENDIX 1 

Some Basic Advantages, Corporate, Stockholder, Security, Economic and 

Public Relations, to Be Gained by Listing Securities on the New York 

Curb Exchange {Statement of the N.Y.C.E.) 

1. The New York Curb Exchange is a primary, highly concen- 
trated, nation-wide, public-auction market for its securities during and 
after a company's vital "growth period." Complete information concern- 
ing these securities is available to the general public through the Ex- 
change and its more than 1,350 member-firm offices located in 360 cities 
in 46 states and the District of Columbia, as well as through the inde- 
pendent statistical services. In addition, 25 Exchange member-firm of- 
fices serve investors in 10 cities outside the United States. 

2. This Exchange is also a seasoning market where companies, 
their securities, managements, products and financial statements are 
constantly studied by Exchange member-firms and discriminating in- 
vestors for indications of potential national growth. 

3. Operating under strict Exchange and government regulation, 
our "specialists" and other brokers, acting as "agents" for the public, are 
held in direct accountability for their business transactions. This protec- 
tion for both the companies and the investing public is augmented by 
the timing of the executions of all orders, rapid reporting on the ticker 
tape, selective membership, audited supervision of member-firms by the 
Exchange, and experienced member committees ever alert to inconsist- 
ent or unsound business practices. 

4. The concentration of business volume on one trading floor re- 
duces the unit cost of operation ( reflected in minimum brokerage com- 
missions ) and establishes in each issue traded a last sale, public appraisal 
price, made daily in competition with hundreds of other stocks. This 
price receives widespread publication each business day and is accepted 
generally as an indication of true value for mergers, consolidations, fi- 
nancial expansion, inheritance taxes, and other purposes and gives in- 
vestors a constant check on their judgment. This market, where volume 
is concentrated and transactions closely supervised, makes successful 
unfair manipulation almost impossible. 

5. Securities listed on a nation-wide exchange are more readily ac- 
ceptable as collateral under normal conditions. 

6. The Curb Exchange is an open market because it is not domi- 
nated by any individual, firm, or group of firms. It is a free market be- 
cause anyone with the money or securities which are traded thereon, in 



McKellar Automatic Machine Company 221 

acceptable form, can have orders executed upon it for a minimum com- 
mission which is standard and known in advance. 

7. The broad geographical distribution of stockholders, which 
follows (over a period) a listing on this Exchange, minimizes the dan- 
gers of too great a concentration of stock in any one area. This is very 
important in cases of regional business recessions when local security 
buying power is severely restricted and distress selling depresses prices 
unduly. Stockholders outside of the depressed area often take advantage 
of lower prices to acquire bargain stock, thus tending to stabilize ex- 
change prices and therefore collateral values and even local banking 
conditions. 

8. Listing has corporate advertising value through the repetition of 
the corporate name in the constant reporting of executions on the ticker 
tape and Trans-Lux machines and quotations over the telephone, tele- 
type, telegraph, and in the leading newspapers of principal cities. When 
a company's securities become known in national investment circles as 
familiarly as the company and its products are known through advertis- 
ing and use, one phase activates the other, with benefits accruing to both. 

9. The prestige and public goodwill achieved by listing a stock on 
a nation-wide exchange emanate from the knowledge that the company 
has agreed to co-operate fully in supplying information about its busi- 
ness to its stockholders, the exchange, the public, and the government. 

10. A very large percentage of the best-known concerns in this 
country are numbered among the approximately 2,200 securities on the 
two New York exchanges. About 800 are listed on the Curb and 1,400 
on the Stock Exchange. 

11. Over 50% of the stocks presently listed on the Stock Exchange, 
or over 700 issues, won their national following and investment support 
through Curb Exchange member-firm offices while originally listed on 
the Curb Exchange. This fact has won for this Exchange the title of 
Seasoning Exchange for the New York Stock Exchange. About 90% of 
the Curb Exchange member-firms are also members of the New York 
Stock Exchange. 

12. Investor and broker interest in a new listing on the Curb Ex- 
change is due to the knowledge that some of the most profitable invest- 
ment opportunities in a company's history occur during its growth pe- 
riod on this Exchange. 

13. A listing on the New York Curb Exchange introduces a com- 
pany to all important investment markets in the country and establishes 



222 Case Problems in Finance 

a solid foundation for a long-term financial program and goodwill 
among discriminating investors. 

14. Additional shares of a well-known stock listed on a nation-wide 
exchange can usually be sold for financial expansion more easily and 
less expensively with a correspondingly greater net return for working 
capital and corporate purposes. In addition, a considerable saving is real- 
ized in the legal expense and detail work necessary for the registration 
of securities under the blue-sky laws of most other states, through prior 
listing on the New York Curb Exchange. 

APPENDIX 2 

Interview with Mr. C. T. Kilman, Partner of Kilman, Luther & Pringle 
(Prominent Over-the-Counter Dealer) 

I explained to Mr. Kilman that we had been approached by the New 
York Curb Exchange and were currently considering the listing of our 
securities on that exchange. I also explained that Mr. Harlow had re- 
called his college friendship with Mr. Kilman and had asked me to get 
his views on the desirability of our listing with the Curb. 

After I explained what I knew about the ownership of our securities 
and the current volume of trading in them Mr. Kilman expressed the 
strong feeling that in our situation we would be making a serious mis- 
take in listing on the Curb Exchange. He stated that he thoroughly ap- 
preciated the validity of the arguments in favor of listing on one of the 
exchanges in the case of companies whose securities were well seasoned, 
widely distributed, and possessed of a widespread market following. 
Such conditions tended to create an automatic generation of orders for 
the stock and a resultant satisfactory activity in the stock on the ex- 
change after listing. He cited Dumont Laboratory, makers of television 
equipment, as an example of a company whose securities are now traded 
in the over-the-counter market but in such volume and by so many per- 
sons that they would unquestionably continue to sell well if listed on an 
exchange. He stated that between 20 and 25 dealers are actively inter- 
ested in this stock. It looked to him, however, as if our stock would be- 
come an "orphan" if it were listed on the Curb Exchange. He felt that 
listing our stock would decrease rather than increase interest in it and 
that a low volume of activity and consequent decline in value would 
result from listing. 

Mr. Kilman explained that his arguments were based on fundamen- 
tal differences between the trading on the over-the-counter market and 



McKellar Automatic Machine Company 223 

on the organized exchanges. Trading in securities on the exchanges is 
done through stock brokers who act essentially as agents for their clients 
in executing orders from the client to buy or sell securities on the floor 
of the exchange. As brokers on the exchange the firms receive for their 
services a commission or fee according to a schedule established in ad- 
vance by the rules of the exchange. In contrast, when acting as an over- 
the-counter dealer, a firm often acts as principal, buying or selling on its 
own behalf. In such transactions the over-the-counter dealer secures re- 
muneration by a spread between the buying and selling price. The latter 
case can also result in a loss if the trader should guess the trend of the 
market incorrectly. Margins of profit are not fixed but are generally 
larger than the commissions allowed brokers. In those instances where 
the "broker" does not act merely as agent, he must show his position as 
principal on the bill to his customer. Such a case may arise where the 
"broker" acts as a specialist (see below). In these instances he often has 
to take a position in order to keep quotations and trading orderly be- 
tween wide swings in the market which sometimes occur quickly. 

Kilman explained that over 100,000 different securities are traded 
in by one or more of the several thousand over-the-counter dealers in 
the country during the course of a year, and more than 7,000 different 
issues are traded quite actively. Most of the dealers tend to center their 
interest in a limited number of stocks and to take a "position," usually 
"long," in the stocks in which they are interested. For example, another 
dealer might call Kilman's "trader" and ask him if he were interested in 
buying 100 shares of McKellar at 9i. If Kilman's trader agrees, it is a 
"deal" without further formality and is consummated in a day or so by 
delivery of the stock certificates and payment by Kilman. This puts 
Kilman in a "long position" to the extent of 100 shares. As the owner 
of these shares, the firm can take any action it desires. Typically, the 
shares will be treated as an inventory item which should be turned over 
as rapidly as possible at a moderate profit. 

In the securities business as in the commodity markets, there are 
wholesale and retail dealers. If Kilman, Luther & Pringle is operating as 
a retail house, a sales force is maintained. If no orders for McKellar stock 
come in, the salesmen or account men may be notified that the firm is 
"offering as principals" 100 shares of McKellar at 10^. Such a spread of 
one point over the purchase price may permit the firm to offer its sales- 
men a commission of one-half point per share, or $50 on the lot. This 
stimulates the salesman to aggressive salesmanship in seeking possible 



224 Case Problems in Finance 

buyers for the security. By seeking out buyers on the telephone or even, 
in some cases, by "ringing doorbells," the salesman will seek to move 
the stock. In many cases the firm may advertise the fact that it is offering 
the particular security at a certain price. As in any other commodity the 
existence of a relatively high margin permits extensive and aggressive 
merchandising. In contrast, the maximum return the broker on the Curb 
Exchange could receive on a 100-share order at approximately 10 would 
be $17.50. This low fee precludes extensive salesmanship on an indi- 
vidual stock. In other words, there is a real incentive to the over-the- 
counter dealer to stimulate trading in particular stocks. In the case of a 
small, not very well-known company, they can set themselves up as 
being particularly interested in the stock and make arrangements to 
carry an inventory of the stock and to be in a position to handle buy or 
sell orders from their customers or possibly from other dealers. Their 
activities tend to assure a constant market for the securities of the com- 
pany and, in Mr. Kilman's opinion, help to give the stock the market 
value that its basic merit warrants. 

On the other hand, the listing of a small, not very well-known issue 
on the Curb Exchange creates a situation in which no broker has any par- 
ticular incentive to encourage his customers to deal in this particular 
security. Sale or purchase of it will giye him no more commission than 
would the sale of a very well-known and much more popular stock. 
Consequently, it had been Mr. Kilman's experience that a number of 
small, not very widely distributed issues had met with unfavorable expe- 
rience after listing. After a brief flurry of preliminary interest, such 
stocks often settled down to weeks of very sporadic activity. In most 
cases, the prices tended to drift lower than the prices that had been estab- 
lished by the more active buying and selling in the over-the-counter 
market. Mr. Kilman cited a number of illustrations to prove his point 
and later sent me further material on these cases so that I could study 
them at leisure. Excerpts from this material follow: 

"... For years we made a market in the Robson-Mattern Company 
Common stock, in fact, we were one of the underwriters in 1936. Dur- 
ing the time this market was over the counter, we were able to interest 
dealers in various sections of the country and over a period of time main- 
tained an orderly, close market with stockholders all over the country. 
The shares traded between $10 and $15 a share, the quotation never 
exceeded half a point and the spread between sales was usually i to ^ of 
a point. This stock was fairly active, and as I recall, we traded on an aver- 



McKellar Automatic Machine Company 225 

age of about 1,000 shares a week. This, of course, was just our volume 
and did not represent the trades of other dealers in this stock. Because of 
pressure on the part of certain stockholders, the bankers had this stock 
listed on the New York Curb Exchange. The adverse effects were imme- 
diately noticeable. There were spreads of half a point to a point between 
sales, all at lower prices, I might add, and there were intervals of some- 
times as much as two weeks between trades. This situation is not un- 
common and is easy to explain. Unless you have dealers, and salesmen, 
if you will, actively engaged in retailing the stock, the amount of interest 
must diminish. Customers' men cannot afford to devote the time neces- 
sary to make these sales merely for a commission. There has to be a 
greater incentive. Moreover, even if there is no public interest in the 
shares at the time a sell order is entered, there are usually several ''spe- 
cialists" or trading houses making a market over the counter, all or a 
few of which will take on some stock for "position." When the shares of 
a relatively inaaive stock are listed, one specialist on the floor takes the 
place of the several over-the-counter firms. Thus, the normal size of the 
professional interest is reduced. 

"Another case that comes to my mind involves the shares cf the 
Wilkins Supply Company. We made a dealer market in the Common 
stock of this company for a dozen years or more. It always enjoyed a 
good, close market and there was a great deal of dealer interest in New 
England, here in New York, Pennsylvania, and on the west coast. The 
company listed these shares in the Pittsburgh Stock Exchange, but we 
continued to make a market over the counter. We believe that 99 % of 
the trading took place over the counter. Sometime in 1946 these shares 
were listed on the New York Curb, with the identical results as outlined 
in the Robson-Mattern Company situation. 

"I want to make clear that I am definitely of the opinion that there 
are a lot of stocks traded over the counter that are eligible for listing. 

"In 1931 we started an over-the-counter market in the Basic Metals 
Corporation when they had less than 60 stockholders. In 1937 the com- 
pany had over 1,000 stockholders and there was a broad, active market 
in the shares. Here we had a situation where, if a block of stock came in 
for sale, there was no difficulty in trading it without resorting to dealer 
distribution. So when the bankers for the company approached me and 
asked my opinion as to whether the shares should be listed on the New 
York Stock Exchange, I had to, in all fairness, agree that it was in the 
best interests of the stockholders to have these shares listed." 



226 Case Problems in Finance 

In support of his argument that hsting by no means insured activity, 
Mr. Kilman cited some figures from a study made in 1946 for the Na- 
tional Association of Security Dealers/ 

A record of the trading on the Curb Exchange for a sample of 50 
stocks was analyzed as to the volume of trading and the number of days 
on which they traded during the first full trading week of each quarter 
of 1946 and during the full month of December, 1946. The analysis 
showed "that the daily average of issues traded during the January week 
was 60% of the list, during the April week 58%, during the July week 
54%, during the October week 50%. During the full 23 trading ses- 
sions studied, the daily average of issues traded was 56% of the list." 
Forty-six per cent of issues analyzed traded fewer than 11, or about one- 
half of the 23 sessions; 27 traded fewer than 6, or about one-fourth of 
the 23 sessions. 

Another study during the first 1 1 months of 1946 showed the num- 
ber of issues not traded in at all during each month ranged from 36 in 
January (4.1% of the entire list) to 68 (8% ) in November. 

He also added that a number of these firms in his opinion would like 
to get back on the over-the-counter market and oif the Curb. However, 
the regulations of the Securities and Exchange Commission made it nec- 
essary for the firm to go through rather extensive formality^ in order to 
delist its securities. Consequently, many firms which were dissatisfied 
with their experience on the Curb had taken no steps to delist. Further- 
more, he felt a natural reluctance on the part of the company executives 
to admit to taking a step that had worked out unfavorably for the hold- 
ers of the stock. 

In regard to the Curb Exchange's general argument, he pointed out 
that the Curb Exchange as an organization maintained a well-paid staff, 
who were very effective in presenting the argument in favor of listing. 
He felt, however, that they were guilty in a number of cases of oversell- 
ing, that is, of encouraging the listing of securities that would be better 
left in the hands of the over-the-counter dealers. 

He further pointed out that the Curb arguments in regard to certain 



^ The National Association of Security Dealers is a self-regulatory body of the over- 
the-counter dealers. Under the Securities Exchange Act such an organization may register 
with the SEC, and thereby is empowered, with the approval of the Commission, to make 
and enforce rules and regulations for its members in respect to standards and praaices. 

^ SEC regulations require that all the stockholders be notified of the proposal to 
delist and that a hearing be held by the SEC to see if the action is justified. 



McKellar Automatic Machine Company 227 

abuses of the public interest by over-the-counter dealers were unfair in 
their implications, since out of a group of more than 4,000 dealers there 
were bound to be a few black sheep. He insisted that this number was 
few and that the great bulk of dealers were of such unquestioned integ- 
rity as to inspire complete confidence on the part of the public. 

Interview with Mr. D. M. Cameron, 
{An Official of the New York Curb Exchange) 

I made myself clear that we conceded the arguments of the Curb to 
the effect that listing had many advantages for a corporation but that we 
were not convinced the Curb was better than the over-the-counter mar- 
ket for preparing the ground to receive future issues of stock. 

His answer to this statement was that the Curb through member- 
firms provided over 1,350 centers in 350 cities where transactions in 
listed securities could be instituted. On the other hand, at the present 
time McKellar was very fortunate if it had three over-the-counter deal- 
ers, probably all located in one geographical area, pushing its stock ( ac- 
tually McKellar has only two dealers pushing its stock, one in New York 
and one in Pittsburgh ) . 

In answer to my query as to whether its listing would make McKel- 
lar an "orphan," he said that when McKellar was first listed and its sym- 
bol came across the ticker tape or Trans-Lux machine several times per 
week or perhaps two or three times in one day, it would be new and 
strange and would arouse the curiosity of the brokers. They would have 
the symbol checked and a brief report made on the company by their 
statistician. He stated that customers' men could suggest purchases of 
stocks by their clients. He maintained that the majority of the brokers 
are always interested in new listings because they realize that the Curb 
carries companies during their growth period. If customers are put in 
good growth stocks, a broker's reputation is enhanced. 

He pointed out that the spread between the bid and asked price on 
the Curb is much less than that existing on comparable stocks traded on 
the over-the-counter market. 

He asserted that over-the-counter dealers are often foolish. When 
they first take over a stock to push it they may g^t a two-point spread;^ 
but as this particular stock becomes more generally known to dealers, 



^ A "spread" is the difference between what a stock is bought for and sold at. 



228 Case Problems in Finance 

the fact that it is underpriced is realized and dealers will commence to 
make a market in it. This increase in competition will result in the 
spread being decreased to the point where it does not compensate the 
dealer for incurring the risk of taking a position. What such a dealer 
should do is use his influence to have the stock listed, take out an associ- 
ate membership on the Curb, which will cost him $2,500, and turn over 
all his business in the security to a broker from whom he will receive 
50% of the brokerage fees involved. In this way he does away with the 
risk of taking a position on the stock with its small spread and is able to 
use his capital on "riding" another stock with a two- or three-point 
spread. Mr. Cameron then gave me some interesting information regard- 
ing operations of over-the-counter dealers. (Summarized in Appen- 
dix 3 [p. 230].) 

In discussing qualifications for listing on the Curb, Cameron stated 
that he would like to see a minimum of 100,000 "free" shares held by 
850 to 1,000 shareholders. Free shares mean those held outside family, 
controlling, or management groups. His contention was that, if from 
800 to 1,000 families owned the shares, their needs and decisions would 
create sufficient activity in the stock to maintain a free competitive auc- 
tion market. He thought it might be advantageous to list both preferred 
and common stocks because that would increase the number of times 
McKellar's symbol would appear on the ticker. He advised that, if list- 
ing was contemplated, it should not be done within eight months before 
or after a new issue. A time when the stock market is relatively stable 
should be selected, so that the stock would not be subject to undue 
pressures. 

Mr. Cameron maintained that large violent fluctuations in the price 
of a listed stock were less likely than when a stock was traded over-the- 
counter. This is because of the activity of a "specialist" broker, one of 
whom is assigned to each listed stock by the Exchange. These specialists 
are charged with maintaining a "fair and orderly" market, which implies 
"the maintenance of price continuity and the minimizing of the effects 
of temporary disparity between supply and demand."* In other words, if 
the last sale of a certain stock was consummated at 10, and if, when the 
next offer of shares was made, there were no buyers in the market, the 
specialist would be expected not to allow the price to go down to perhaps 
7 but would be obligated to supply a bid at 9i or 9|. This broker is not 
supposed to interefere with market fluctuations that are due to the mar- 



^New York Stock Exchange Directory and Guide. Supplementary Material, p. E-195. 



McKellar Automatic Machine Company 229 

ket appraisal of the security but merely with violent price fluctuations 
that he feels are due to a temporary lack of buyers or sellers in the 
market. 

Interview with Mr. F. M. Doherty of the Investment Department 
of the Peninsular Trust Company of New York 

I questioned him on the policy of the Trust company in regard to 
investing in unlisted securities. 

First, he made the statement that he wouldn't consider investing 
trust funds in a corporate stock unless it was on the "Big Board" (New 
York Stock Exchange ) . Then he said that, occasionally, they purchased 
stocks that were listed on the Curb. The only securities they bought on 
the over-the-counter market were government and municipal bonds and 
bank stocks. He maintained that, in general, unlisted companies were 
weak and of limited capitalization. If an institution started buying a 
stock of such a company, it would soon own the concern. It was a mat- 
ter of volume to them. Furthermore, they want to be able to go in or out 
of the market without affecting the price. He showed me a list of perhaps 
150 stocks they were interested in, all of which were listed on the 
NYSE. In each company they had from $1,000,000 to $20,000,000 in- 
vested for the estates, etc., that the Trust company managed. 

He seemed to think that the over-the-counter business often at- 
tracted those who were not as reputable as they might be. Hence, a trust 
company (he emphasized the word "trust") avoided them as much as 
possible because it was too much trouble to make sure they were getting 
the best possible prices. However, he said later that they often handle 
large blocks of stock, especially preferreds, through the over-the-counter 
dealers but here they have the exchange prices to guide them. He made 
the comment that the banks were very reluctant to lend money against 
unlisted securities because they were unable to keep an accurate check of 
their collateral values with such securities. This lack of published actual 
prices and volumes also made these stocks unpopular with the "chart 
reader" investor who was interested in such data for clues as to when to 
buy or sell. 

I had considerable discussion with Doherty and two of his colleagues 
over the question of stocks selling at a higher price when listed. After 
deliberation, he stated that unlisted stocks sold from 25 % to 35 % lower 
than they would if they were listed. He made an interesting comment at 
this point that they frequently got away with 50% of the actual value 
for estate valuation purposes when it came to nonquoted securities. 



230 Case Problems in Finance 

APPENDIX 3 

Summary of Brief of New York Curb Exchange 

Re: Application to SEC to Extend Unlisted Trading 

Privileges to Certain Companies, 1944^ 

The principal thesis of the brief, prepared by the Curb Exchange, 
was that the cost to the pubHc in its deahngs over the counter is mate- 
rially greater than the cost to the public of comparable dealings on the 
Exchange. It was shown that public purchasers bought from dealers 
within a price range which was very much higher than the price range 
within which public sellers were selling to or through dealers on the 
same day, and, further, that dealers traded among themselves at prices 
which ranged in between the prices paid by public purchasers and re- 
ceived by public sellers on the same day, as shown in the following table: 



Average of Daily Lowest and Highest Prices 

Public Between Public 

Sales Dealers Purchases 

Company Lowest Highest Lowest Highest Lowest Highest 

Lukens $10.57 $10.79 $10.81 $11.12 $11.54 $12.21 

Merck 34.29 34.77 34.70 35.31 35-33 36.08 

Northern 26.39 28.26 27-81 28.76 28.68 30.45 

Public Service ... . 14.00 14.74 14.56 15.02 15-14 15-99 

Warner 11.02 11.49 11.34 11.82 12.06 12.82 



AVERAC 


tE Daily 


Difference be- 


tween 


Lowest 


AND Highest 


Dealers 


Public 


$0.31 


$1.64 


0.61 


1.79 


0.95 


4-06 


0.46 


1.99 


0.48 


1.80 



It will be noted in the above table that in each stock the average 
daily range per share between dealers (from 31 cents in Lukens up to 
95 cents in Northern) is a mere fraction of the daily range between the 
lowest sale and highest purchase prices for transactions made with the 
public (from $1.64 in Lukens up to $4.06 in Northern). 

The above table, being prepared on an averaged basis, tends to con- 
ceal some striking examples of concurrent over-the-counter prices. As an 
illustration, shown below are the actual daily figures for three consecu- 
tive days in Public Service: 



^Securities and Exchange Commission Release No. 3658, February 20, 1945. Applica- 
tion was denied "the Commission finding that it was not in the public interest ... to 
extend privileges to the subject securities as to which there did not exist duties substantially 
equivalent to all the duties that devolve upon issuers, officers, directors, and 10% stock- 
holders by virtue of the provisions of this Act." 



McKellar Automatic Machine Company 



231 





Public Sales 


Between Dealers 


Public 


Purchases 


Range — Public 




Highest Lowest 


Highest Lowest 


Highest 


Lowest 


Lowest Sale 


Date 


Price Price 


Price Price 


Price 


Price 


Highest Purchase 


1/14/43 


$13,000 $11,973 


$13,250 $13,000 


$14,375 


$13,875 


$2,402 


1/15/43 


13.250 5.000 


13.375 13.000 


14.500 


13.375 


9.500 


1/16/43 


12.967 12.967 


13.500 13.125 


14.000 


13.750 


1.033 



As seen from the above table some public sellers received on Janu- 
ary 15, $5.00 per share (lowest public sale price) while others received 
$13.25, and public buyers paid from $13,375 to $14.50, and dealers 
trading among themselves from $13.00 to $13,375. The $5.00 per 
share price certainly could not be attributed to general market action or 
trend in the light of the price range in other transactions on the same 
day and on the preceding and following days. It would be interesting to 
hear the explanation of the dealer whose indicated spread on the trans- 
action was $8.00 per share, or more than one and a half times the total 
proceeds of $5.00 per share received by his customers. 

In all five stocks a very substantial number of the public purchases 
and sales were made with dealers acting as principals. The great majority 
of the shares which the public bought from or sold to these dealers was 
offset by the dealers on the same day. That is, the public purchased from 
or sold to a dealer who on the same day effected an offsetting purchase 
from or sale to a dealer of an equivalent amount of the same stock. In 
other words, most of the public purchases and sales were offset or 
"matched" by the dealer in transactions with other dealers. 

The dealer's spread represents the cost to his public customer. In 
matched public purchases the spread ranged up to $2.00 per share for 
Lukens, approximately $3.00 in Merck, over $2.00 in Northern, ap- 
proximately $1.50 in Public Service, and over $2.00 in Warner. 

Continuing, the brief maintains that the general practice among 
dealers of offsetting public purchases and sales minimizes the dealers' 
risks to the extent that they were little, if any, greater than the risks in- 
volved in agency transactions executed over the counter or on an ex- 
change. This is evidenced by the fact that, out of a total of 1,756 
matched public purchases and 699 matched public sales in all five 
stocks, only 2% of the purchases and 5% of the sales were matched 
with another dealer at a loss. 

The average spread per share in these matched transactions in con- 
trast with the comparable commission rates of the applicant exchange is 
shown in the following table: 



232 Case Problems in Finance 

OvER-THE-CoUNTER SpREAD CoMMISSIOn ON 

Matched Public Matched Public Exchange 

Purchase Sale in Unit of Trading 

Lukens $0.89 $0.27 $0.15 

Merck 1.03 0.61 0.22 

Northern 1.22 0.48 0.20 

Public 

Service 0.77 0.37 0.20 

Warner 0.82 0.33 0.16 

It will be noted that the spread in matched public sales is less than 
that taken in matched public purchases. This is because the proceeds 
from such sales are usually reinvested by the customer in other securities 
over the counter, and it is the practice of dealers to obtain a larger part 
of their profits from the customer's new over-the-counter purchase than 
from his liquidating sale. 

The spreads which the dealers charged their own public customers 
in transactions offset by such dealers on the same day were only a part of 
the total cost to the public. In all five stocks there were some three- 
dealer chains ( in which a public seller sold to a dealer, who resold to a 
second dealer, who resold to a third dealer, who resold to a public pur- 
chaser, all in the same day), some two-dealer chains, and some one- 
dealer chains. In many such chains in the five stocks, one or more agents 
were involved in addition to the dealers. The total cost to the public in 
the average chain transaction of each type is set forth in the following 
table: 



Over-the-Counter Average per Share by Which Purchase Exchange 



Price Exceeded Selling Price on Same Day 

4-Dealer 3-Dealer 2-Dealer 1-Dealer 

Chain Chain Chain Chain 

Lukens $1.44 $1.20 $0.79 

Merck 1.77 1.37 0.88 

Northern 2.30 1.78 1.09 

Public Service $1.50 1.14 1.23 0.85 

Warner 1.42 1.29 0.94 



Total Commis- 
sion of Buyer 
and Seller 

$0.30 
0.44 
0.40 
0.40 
0.32 



The Curb's brief argues that the excess cost borne by the public in 
its dealings over the counter is directly related to the mechanics of the 
over-the-counter market. Transactions between dealers account for the 
majority of the transactions and share volume in all five stocks. The ex- 
planation of this significant circumstance is that in stocks actively dealt 
in over the counter, such as the stocks involved here, the market gener- 
ally revolves around certain dealers who "make" the market and trade 
primarily and actively with other dealers. Around this core is a very 



McKellar Automatic Machine Company 233 

much greater number of dealers who trade with the public and offset 
public transactions with other dealers, usually on the same day. Thus, 
while the transactions between dealers account for the major part of the 
trading volume in five stocks, such transactions rarely represent investor 
interest but are merely the mechanism whereby shares are transferred 
from public investor to public investor. As has been shown above, the 
transactions between dealers are made within price ranges which vary 
materially from the prices concurrently being paid and received by the 
public. 

The "two-market" pattern is reflected in the dual system under 
which quotations are disseminated for over-the-counter securities. There 
are the dealer quotations which are carried in the National Daily Quo- 
tation Service sheets, and there are the public quotations which are car- 
ried for a limited number of securities in certain newspapers. 

According to the brief, the National Daily Quotation Service is only 
available to dealer subscribers and a few institutions. The public does 
not have access to these quotations. The only quotations available to the 
public are those carried in a limited number of newspapers. These are 
not bid and asked prices but rather prices or spreads which are arbitrarily 
established by various formulae. The effect of the formulae is to lower 
the bid arbitrarily and/or raise the offer then prevailing in the dealers' 
market. The spreads between the bid and asked prices as published in 
the newspapers are generally so wide that most public transactions can 
be made within such spreads. Consequently, if a customer buys a stock 
at a slightly lower than the published offered or sells at a slightly higher 
than the published best price, he is generally satisfied because he does 
not know, and has no way of ascertaining, that lower offers and higher 
bids prevailed at the time of his transactions. Public purchasers of each 
of the above five stocks consistently paid higher prices than the low of- 
fered in the National Daily Quotation Service sheets of the same day, 
and public sellers of each of the five stocks consistently received lower 
prices than the high bid in such quotation sheets of the same day. The 
margin of difference between such quotations and prices actually re- 
ceived or paid by the public was very substantial. 

The dual system over the counter of two contemporaneous markets 
(dealers and customers) and two contemporaneous sets of quotations, 
of which the public has knowledge of one and the dealer of both, and 
the nonpublication of prices at which purchases and sales are made are 
characteristics of the over-the-counter market which evolve from the 
general practice of effecting transactions on a principal basis. 



234 Case Problems in Finance 

The Curb's brief argues that, in contrast to the over-the-counter 
market, the Exchange market is a pubHc, competitive market wherein 
bids of potential buyers and offers of potential sellers are, through bro- 
ker agents, concentrated at a single focal point in a public competition 
under auction rules. Transactions are effected as a result of the meeting 
of the highest bid and lowest offer. All transactions are in the open. The 
Exchange maintains a quotation system through which a member may 
know actual quotations bid or asked at any moment. A quotation is a 
firm bid or offer in at least the unit of trading. It is actual at the time 
given, not nominal or subject to negotiation. If it is accepted, the mem- 
ber making such a bid or offer is bound by the quoted price. 

The Exchange is principally an open agency market. An order given 
to a member of the Exchange is accepted by that member as agent. 
The fiduciary relationship then imposes upon the broker definite respon- 
sibilities. He may not buy or sell for himself at the same or better price 
without first executing his customer's order. Rule 5 of the Exchange spe- 
cifically contemplates that the member must seek the best market for 
his customers, whether that market be on or off the Exchange. For his 
services the member is paid a commission known to his customer and 
established by a public schedule of commissions. 



(VVVVVVVVVVVVVVVWAAVVV*\VWV\AVM\VVVVWA\VVVVV\V^^ 



Boston Edison Company 



A\VV\VV\VVVV\VV\VVV\\^VV\VVVVVWWV\VVVWVVVV\A\VVVV\A\VVVVVV^^ 



The terms on which new issues of high-grade utihty bonds were 
being issued and on which outstanding issues were being traded in the 
fall of 1940 appeared to be very favorable for bond financing. As shown 
in Chart 1, a historical low in yields had been reached. Yields on high- 
grade corporate bonds had declined more than ^% since 1935, when 
the Boston Edison Company had sold an issue of $53,000,000, par 
value, of 3i% first mortgage bonds maturing July 1, 1965. At that time 
the bonds were sold at a premium so that net annual cost to the company 
was 3.39%. The investor's yield to maturity was 3-30%. Because of the 
decline in yields from 1935 to 1940, it was deemed desirable to refund 
this issue. 

The Boston Edison Company, an operating company engaged in the 
sale of electricity and steam, in 1940 was supplying electricity directly 
to approximately 40 communities located over an area of 580 square 
miles. Electricity in bulk was sold to other electrical companies, munici- 
palities, and very large users. Steam sales were limited to the city of 
Boston. Other activities included the operation of a radiobroadcasting 
station and the purchase and sale of electrical appliances. Earnings fluc- 
tuated little and did not fall off greatly even during the depression of 
the early 1930's. Boston Edison bonds were considered by investors as 
being among the highest quality utility issues available. 

In the fall of 1940 the company's investment banker, after consid- 
ering the state of the market, estimated for planning purposes that the 
company could at that time sell an issue of 30-year bonds on a 2.70% 
basis to the public. The rate of interest cost to the company was esti- 
mated at 2.76%, allowing for the costs of the issue. On that assumption, 
a calculation of the savings that would result from the refunding was 
drawn up and is given in Exhibit 1 . In making the estimate, the corpo- 
rate income tax rate was assumed to be 24% over the 30-year period. 
The calculation indicated that substantial savings were possible. 

235 



^ = 5 



05 = 

UJ 2 1 
2 S o 
'^ ^ ^ 

= 

CD "r = 



<o CM^; 



Boston Edison Company 237 

After it was decided to proceed with the refunding, the Boston Edi- 
son Company and its advisors decided upon the details of the indenture 
of the new issue, such as sinking fund retirement, call prices, and others. 
The bonds were to bear interest from December 1, 1940, and to be due 
December 1, 1970. 

On November 25, 1940, the Boston Edison Company advertised for 
competitive bids by bankers for the purchase of the entire issue. Bidders 
were permitted to bid on the coupon rate of either 2|% or 3%. As ap- 
pears in Exhibit 2, the highest bid, which was the one accepted, was of- 
fered by the company's investment banker, the First Boston Corpora- 
tion. The proposed yield to investors, 2.5 1 %, was lower than previously 
attempted for issues of this kind. 

Public offering took place on December 4. The issue was successful. 
December 10 was the date of the payment by the underwriters to the 
Boston Edison Company for the issue. Since the bonds were dated De- 
cember 1, nine days' interest, or $36,438, was added to the price named 
in Exhibit 2. On the same date, the company gave the required 30-day 
notice of redemption of the outstanding first mortgage bonds at 107 and 
accrued interest to January 10. The sum of $154,583 was allotted to 
this interest accrual in addition to the interest unpaid to December 10, 
1940. 

In the 1940 annual report to stockholders, the company commented 
on the refunding as follows: 

As a result of the refunding and after the amortization of the net balance 
of the call premium [from the first few years' annual savings in coupon pay- 
ments], the company will have the use of the money borrowed for [the re- 
mainder of the 30 years] at the rate of 2.6%, which is an exceptionally low rate 
for the bonds of a public utility having a maturity of 30 years. 



238 



Case Problems in Finance 



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rtA\VV\VVVV\VV\VVVV%VVVt\VVVWWVVVVVVVVVVWVVVVV\VVV\\VV\V^^ 



Loose- Wiles Biscuit Company 



fV\VV\\\VVVVVVVVVVVVVVVVV\V\A/VVVV\\VV\\VVVVVVVV\V\A\V\/V\VVV^^ 



Under date of July 8, 1935, the president of Loose- Wiles Biscuit 
Company wrote the stockholders that "your directors believe that the 
present is a favorable time to refund the corporation's Seven Per Cent 
First Preferred Stock by means of a preferred stock issue with a lower 
dividend rate. This is made possible not only by current money market 
conditions, which have changed materially since the present preferred 
stock was issued, but by the high credit standing of the corpora- 
tion. . . ." At the time, 35,008 shares of $100 par 7% cumulative 
preferred stock were outstanding. The stock was callable on 60 days' 
notice at 120 plus accrued dividends. 

On August 14, 1935, the company offered to the holders of the 7% 
preferred the right to subscribe pro rata to a new issue of 5 % preferred 
stock at 101. The proceeds were to be used to retire the 7 % preferred on 
October 1. The offer to the shareholders of the 7% preferred was good 
for 10 days. A group of investment banking firms agreed to purchase 
those shares not taken up by the old stockholders. In return the bankers 
received a stand-by underwriting fee of $1.50 for each share sold to the 
holders of the old 7% preferred stock or $2.00 per share for each share 
purchased by them. The offering proved successful, with a substantial 
portion of the offering taken up by holders of the 7 % preferred. The 
7% preferred was retired on October 1. In addition to an outlay of 
$700,160 for call premium on the 7% preferred stock retired, the com- 
pany incurred total expenses of $162,167 in connection with the call of 
the old stock and issue of the new. However, the new stock was sold at a 
premium of $42,000. The expenses of refunding the preferred issue and 
the premium on the new preferred stock did not affect taxable income 
for the year. 

The first trading in the new 5 % preferred stock on the New York 
Stock Exchange was at a substantial premium above the ofifering price 

240 



Loose-Wiles Biscuit Company 241 

to the old stockholders. During the remainder of 1935 the 5 % preferred 
stock ranged between a low of 107| and a high of 112. 

On June 16, 1941, the company sold an issue of $4,000,000 of un- 
secured promissory notes at face value to the Prudential Insurance Com- 
pany of America. The notes were due serially to 1956 and carried an 
interest rate of 3%. The proceeds of the sale of the notes, together with 
funds from the company's treasury, were used to retire the entire issue of 
the company's 5% preferred stock. The issue was called at 105 on 
July 1, 1941. 



/VWVVVVVVVVVVVVVVVVVVVVV\AA/VVV\V\AA\V\AAA\VWVAVV\VVV\^^ 



Bebb Corporation 



ftVVVVVVVVVVVVVVtVVVVVVVVVVVV\VVVVVVVVVVV\AVVVVVVV^^ 



In April, 1942, the management of the Bebb Corporation, a manu- 
facturer of kraft paper, corrugated board, and boxes widely used for 
many commercial purposes, had arranged with two banks for loans to 
provide working capital to finance a volume of sales in excess of that 
which had been anticipated. At the same time as the working capital 
question arose, the management was considering whether under the cir- 
cumstances it should continue to appropriate funds for the purchase and 
subsequent retirement of the preferred stocks of the company. If such a 
policy were to be continued, the company would be required to decide 
whether it should continue purchasing shares in small lots from time to 
time or should call the entire issue of the outstanding preferred stocks, 
at the redemption price. In the latter case, some sort of a refunding issue 
would be necessary. 

Balance sheets and earnings statements of the company for the years 
1939-1941 will be found in Exhibits 1 and 2, together with a summary 
of income figures from 1929 through 1938 and the current position at 
March 31, 1942. A change in the efficiency of operation will be noted. 
In 1939 the company had made a careful study of its production costs 
and sales margins and subsequently had made substantial changes in 
policy, the results of which were reflected in the increased rate of earn- 
ings in 1940. It was believed that this increase in efficiency could be 
maintained in future years. On such a basis, the management felt that, at 
an annual sales volume of $14,000,000, net profits would be adequate 
to provide for suitable dividends on all classes of stock. Plans in regard 
to financial needs had been made in 1939 on the assumption that an 
annual sales volume of 1 14,000,000 was a practical goal, at least in the 
foreseeable future. There would be no need to force sales, by cutting 
margins, to reach higher totals. 

242 



Bebb Corporation 243 

In handling $14,000,000 annual sales the company had normally 
borrowed about $600,000 for four peak months, September through 
December. Bank credit for these seasonal loans and occasional tempo- 
rary loans to permit the purchase of blocks of the company's own stock 
had been obtained without difficulty. All such loans had been repaid 
promptly out of seasonal liquidation or out of earnings. The company 
maintained principal banking relationships with two large city banks 
and had regularly been told by them that its credit was so strong that the 
seasonal loans requested were well within the limit that the company 
would be able to borrow. 

The coming of the defense program and the war had led to an in- 
creased volume of orders for the standard products of the company. 
Some novelty lines with low margins had been cut out in an attempt to 
keep the volume of sales down to the budgeted $14,000,000 a year, but 
demands for special types of containers for military use developed so 
rapidly that sales for 1941 were approximately $19,500,000. During 
the first three months of 1942 the sales of the Bebb Corporation were 
$5,456,000, an increase of $1,272,000 over the same period in 1941. 
Unfilled orders at April 1 totaled $4,104,000, slightly less than the pre- 
vious year; but it was estimated that the year's sales would exceed the 
1941 rate. The rate of profits on sales was about the same as 1941. 

The treasurer's budget of working capital needs, based on such a 
volume, indicated that the company would need to borrow heavily for 
the fall. The maximum loan for financing working capital requirements 
at that time would amount to about $1,200,000; and, so long as the 
volume of sales was maintained at approximately $20,000,000 a year, 
a minimum of about $600,000 would need to be borrowed even at the 
low point of the year. 

Pending a determination of the question, the treasurer of the com- 
pany had not included in his budget any provision for the continued pur- 
chase of shares of the company, as had been a recent policy. 

The treasurer's preliminary negotiations with financial institutions 
had developed the following facts. Each of the company's two banks was 
willing to extend a line of credit to the company for the needed working 
capital funds. The exact amount of the maximum line that would be 
available was not mentioned, but the treasurer thought $1,200,000 
could be borrowed without difficulty and without pressure for prompt 
liquidation. It was understood that the loan would rotate from bank 
to bank on a six-months basis so that neither bank would carry the 



244 Case Problems in Finance 

company's debt continually. The rate of interest would be 1 ^ % per year 
initially but would vary as the level of interest rates might change. 

In addition, the treasurer had talked with investment bankers about 
refunding the two types of preferred stock outstanding with an issue of 
20-year debenture bonds. It was understood that a $6,000,000 issue of 
bonds with a 4|% coupon could be sold to net the company the par 
price. Although details had not been worked out, the bankers had stated 
that three provisions would have to be included in the indenture: (1) 
that all debt, current and fixed, should not exceed 175% of the cur- 
rent assets; (2) that the company could not mortgage any property 
while any of the bonds were outstanding; ( 3 ) that the bonds would be 
callable in whole or in part at 105% of the public issue price. 

The first preferred stock and the common stock of the company were 
listed on an organized exchange and were widely held, although infre- 
quently traded. The 7 % preferred stock was unlisted and had been al- 
most completely inactive since 1939. 

In recent years the company had begun to acquire shares of various 
classes of its stock, in the open market and through occasional tender 
offers, as part of a plan to simplify its capital structure and to reduce its 
outstanding capitalization by the retirement of the stock so purchased. 
The number of shares of the various classes of stock acquired and the 
average prices paid, in the years 1940 and 1941, are tabulated below: 

, 1940 , , 1941 , 

No. of No. of 

Shares Average Shares Average 

Class of Stock Acquired Cost Acquired Cost 

1. 8% first preferred 830 $96.91 6,530 $118.75 

2. 7% preferred 980 80.51 730 111.93 

3. Common 52,000 4.28 6,200 3.88 

By April 1, 1942, it was clear that few, if any, more shares of the 
7% preferred stock could be obtained without call. Blocks of shares of 
first preferred stock continued to come on the market from time to time, 
principally from trust accounts and estates which desired to liquidate 
some of their investments. The only quotation so far recorded in 1942 
was in the week of March 16, at $123 per share. The number of shares 
traded that week was 10. 

The provisions of the capital stock issues are summarized in Ex- 
hibit 3. 

On February 1 the company paid a regular quarterly dividend 
(2% ) on the first preferred stock. The arrears ($82 per share) on the 



Bebb Corporation 245 

small number of shares of 7 % preferred stock were partly paid up in 
1941 and fully paid up March 31, 1942, by payment of $4,303 on that 
date. One of the reasons for this payment was to clear the way for pos- 
sible payments on common stock in the ensuing quarters. At April 1, 
1942, there were no arrearages on either preferred stock. There had been 
no dividends paid on the common stocks since 1932. The current posi- 
tion of the company on March 31, 1942, was as shown in Exhibit 1. 



246 



Case Problems in Finance 



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248 Case Problems in Finance 

Exhibit 3 

BEBB CORPORATION 
Certain Provisions of Outstanding Capital Stock, April 1, 1942 



Actually 
Outstand- 
ing 


8% 1st Pfd. Stock 
Par $100 
38,480 shares 


7% Pfd. Stock 
Par $100 
120 shares 


Common Stock 
Par $3 
365,800 shares 


Redemp- 
tion Pro- 
visions 


Whole outstanding is- 
sue callable on 90 
days' notice at $150 
and accumulated divi- 
dends. Not redeemable 


Whole outstanding is- 
sue callable on 90 
days' notice at $115 
and accumulated divi- 
dends. Not redeemable 


None 




in part. 


in part. 




Sinking 

Fund 

Provisions 


In any year at least 5% of earnings after pre- 
ferred dividends must be used to purchase pre- 
ferred stocks. 


None 



Voting 
Power 



So long as interest and sinking fund charges on 
any funded debt and cumulative dividend require- 
ments for all classes of preferred exceed $300,000 
annually, company must pay no common divi- 
dends without allotting a sum equal to one-fourth 
of common dividend for the reduction of debt or 
the purchase of first preferred shares. At least one- 
half the allotment must be used to purchase first 
preferred stock. Also, at least one-fourth of the 
common dividend must be paid in stock. 



Obtains 10 votes per 
share whenever divi- 
dends are $12 or more 
in arrears and also the 
right to elect two-thirds 
of the Board of Direc- 
tors. Otherwise, does 
not vote. 



None 



One vote per share. 



Dividend 8%, senior to all other Junior to first pre- 

Priority classes, fully cumula- ferred, senior to all 

t'we. others. 7% fully cumu- 

lative. 



Dividends may not be 
paid unless remaining 
surplus would amount 
to at least one year's 
dividend requirement 
on both preferred 
stocks. 



Dividend No arrearages. Divi- 

ReCORD dends not paid in 1932 

and part of 1933 were 

fully made up by the 

end of 1937. 



No regular dividend 
since 1931. Arrearages 
all paid up by April 1, 
1942. 



No dividend 
1932. 



(\\V\VVV\AAA\VVVVV\\VV\VVVVVVVV\VVVVVVa\V\\VVVVV\>AVVVV^ 



American Woolen Company' 



tVVVVVVW\VVVVVVVM^A\VVVVVV\\A\\AA^^\VVV\VV\A\VV\VV\\VWV\V^^ 



In June, 1946, the preferred and common stockholders of the Amer- 
ican Woolen Company were asked to approve a plan of recapitalization 
proposed by the directors of the company. Since the plan involved basic 
changes in the company's Articles of Incorporation, the approval of 
stockholders owning two-thirds of each class of stock — preferred and 
common — was required. 

The recapitalization plan sought to eliminate dividend arrearages on 
the 350,000 shares of 7% cumulative, noncallable, preferred stock out- 
standing. Elimination of the arrearages, which on June 3, 1946, 
amounted to $20,475,000, or $58.50 per share, would make legally 
possible the resumption of dividend payments on the 400,000 shares of 
common stock of the company. The common stockholders had received 
no dividends for 22 years, the last payment having been in July, 1924. 

After many years of low profits or operating deficits, the company 
had made substantial profits during the war years. Earnings and pre- 
ferred dividend payments are shown in Exhibit 1 (p. 255 ) . The balance 
sheet for 1945 is given in Exhibit 2. 

In the annual report to stockholders dated February 20, 1946, the 
president of American Woolen had discussed the problem of the arrear- 
ages in the light of recent profitable operations of the company. He said: 

During the 10 years ended December 31, 1945, the company paid dividends 
totaling $70.00 per share on the Preferred stock, an average of $7.00 per year, 
which was just enough to keep the Preferred dividends current without reduction 
of the unpaid accumulations, which were $58.75 on December 31, 1935, and the 
same amount on December 31, 1945. While some of the years during this 10-year 
period were years of loss or less than average earnings, the war years were profit- 
able; and the whole period should be regarded as one of more than average pros- 



'^ The material in this case is from various pubHshed sources. 

249 



250 Case Problems in Finance 

perity, with average earnings at least equal to, and probably in excess of, what 
may be expected during the reconversion period and thereafter. A net reduction 
of the accumulations on the Preferred stock during the next few years is not 
impossible, and may even be regarded as probable, but it is highly improbable 
that earnings will permit the payment of the entire accumulations, which must 
happen before dividends can be paid on the common stock. 

For this and other reasons, and with the benefit of suggestions from many 
interested stockholders, both Preferred and Common, the Officers and Directors, 
during the past year and particularly during recent months, have given a great 
deal of thought and consideration to the question of recapitalization for the pur- 
pose of eliminating the accumulated unpaid dividends on the Preferred stock 
which amounted, as previously stated, to $58.75 per share on December 31, 1945, 
or a total of $20,562,500. If the many legal technicalities and other difficulties 
can be satisfactorily overcome, a detailed plan will be submitted to the stock- 
holders for approval at a special meeting to be called for that purpose. The man- 
agement is hopeful that the problem will be solved, but no definite assurance can 
be given at this time. 

On March 26, 1946, at the annual meeting of stockholders, a tenta- 
tive plan of recapitalization was disclosed. At the same meeting, accord- 
ing to newspaper reports," President Moses Pendleton said he expected 
that distribution of at least 75% of earnings would be made in 1946, 
with the larger part of the payment in the second half of the year. 

Despite many uncertainties, operations in the early months of 1946 
continued at a high and very profitable rate. 

At a special meeting on April 30, the board of directors voted to 
recommend a revised plan of recapitalization to the stockholders. A 
letter describing the proposed plan and calling a stockholders' meeting 
for July 3 to vote on the proposal was mailed on June 3. A major por- 
tion of the letter follows: 

To THE Stockholders of 

AMERICAN WOOLEN COMPANY: 

Accompanying this letter is a Notice of Meeting and Proxy Statement, to- 
gether with a Proxy, relating to a Special Meeting of Stockholders to be held 
July 3, 1946. The purpose of the meeting is to consider and take action upon a 
Plan of Recapitalization of your company. 

It has long been apparent that a revision of the capital structure of the com- 
pany is desirable. As you have been advised in the Annual Reports, this subject 
has been given almost constant study for the past several years. During this pe- 
riod dozens of plans submitted by stockholders, banking houses, and independent 
financial experts have been reviewed and a great deal of time and effort has gone 

^Commercial and Financial Chronicle, April 1, 1946. 



American Woolen Company 251 

into the preparation of the Plan now submitted to you. It is presented with the 
unanimous approval of your Directors as being fair and equitable and in the 
interest of both Preferred and Common stockholders. Please give it careful con- 
sideration and mail in your proxy promptly. 

Historical Review 

The predecessor American Woolen Company was organized in 1899 and the 
terms of the present 7% noncallable Preferred stock and the Common stock were 
created at that time. The history of the company since then falls naturally into 
three periods. Until shortly after the First World War the company maintained 
a relatively stable earning power. During the next period, up to the outbreak of 
the recent war, profit margins declined sharply as a result of price competition 
induced by the substantial overcapacity that had been built up in the industry, 
the development of competing fabrics and the increasing competition from 
woolen imports produced by cheap foreign labor. The present period, beginning 
with the outbreak of the last World War, saw an abnormal demand for woolen 
fabrics and the practical elimination of imports so that the company has been able 
to operate steadily at a high rate of production. 

The mills are now working at a high rate of capacity and earnings are cur- 
rently running at a very favorable rate. It is impossible to predict how long these 
conditions will continue. The Wool Textile Industry in the United States has 
much too great a productive capacity in relation to the normal demand. English 
and European mills are making every effort to resume volume production. Once 
the present world shortage of woolens is satisfied we must look forward to a re- 
turn of the highly competitive conditions existing prior to the war. The problem 
of meeting foreign competition under the lower tariffs established in 1939 will 
be intensified by high labor costs. 

The Present Situation 

For many years the company has been seriously burdened by the excessive 
amount of noncallable Preferred stock carrying a fixed dividend rate of 7%. 
Dividend accumulations on this stock now amount to $20,475,000 and one of the 
most serious problems confronting the company is the elimination of these divi- 
dend accumulations and the correction of the present inflexible capital structure. 

The company now has outstanding 350,000 shares of 7% noncallable Pre- 
ferred stock of $100 par value and 400,000 shares of Common stock without par 
value. Dividend accumulations on the Preferred stock amount to $58.50 per 
share, or an aggregate of $20,475,000. The annual dividend requirement on the 
Preferred stock of $2,450,000 is currently being earned by a wide margin but 
from the organization of the predecessor company in 1899 through 1942 average 
earnings were less than the annual dividend requirement on the Preferred stock 
now outstanding. Even including the high earnings of the past three years, such 
dividend requirements would have been covered by only a slight margin. 

In the opinion of your Directors, the present inflexible and top-heavy capital 
structure will prove a serious burden unless corrected. 



I 



252 Case Problems in Finance 

Exchange of Stock 

The Plan contemplates the creation of a new class of $4 Cumulative Con- 
vertible Prior Preferred stock to be offered in exchange for the present 7% cumu- 
lative Preferred stock on the basis of 1^ shares of the new Prior Preference stock, 
plus $8.50 in cash, for each share of the present Preferred stock with its right to 
accrued dividends. The new Prior Preference stock will be without par value; 
will be preferred over any unexchanged 7% Preferred stock and the Common 
stock as to dividends to the extent of $4 per share per year and as to assets to the 
extent of $105 per share in voluntary and $100 per share in involuntary liquida- 
tion, in each case plus accrued dividends; will be callable at any time on or after 
September 15, 1951, at $105 per share plus accrued dividends; and will be con- 
vertible at any time into 2 shares of Common stock. For a more complete state- 
ment of the provisions of the new Prior Preference stock, reference is made to 
the Proxy statement. 

Advantages of the New Capital Structure 

To the extent exchanges are made pursuant to the Plan, the dividend accu- 
mulations on the present Preferred stock will be eliminated without any substan- 
tial cash drain upon the company, and, since it is intended to pay promptly 
accrued dividends on any unexchanged Preferred stock, the way will immediately 
be opened for dividends upon the Common stock. At the same time regular pre- 
ferred dividend requirements will be reduced and provision made for the even- 
tual reduction of senior capital either by redemption, or through conversion of 
the new Prior Preference stock into Common stock. 

The Plan in Relation to the Preferred Stockholders 

The holders of the present 7% cumulative Preferred stock now have a first 
claim upon the earnings of the company to the extent of $7 per share annually, 
plus accrued dividends of $58.50 per share. Furthermore, their present stock is 
noncallable. Under the Plan they will be offered the right to exchange each share 
of present Preferred stock with its right to accrued dividends, for 1^ shares of 
$4 Prior Preference stock plus $8.50 in cash. Each share of such stock will be 
convertible into 2 shares of Common stock and may be redeemed after five years 
at $105 per share plus accrued dividends. The new Prior Preference stock re- 
ceived in exchange for each share of present Preferred will have an aggregate 
dividend preference of $6 annually. 

While the Preferred stockholders who make the exchange will forego any 
right to receive payment of the accrued dividends on their present stock, and will 
accept a reduction of $ 1 per share in the aggregate dividend rate, they will receive 
new stock having a liquidation and redemption value, plus cash, equal to or 
greater than the par value plus accrued dividends of their present stock. Further- 
more, each share of the new Prior Preference stock will be convertible into 2 
shares of Common stock or a total of 3 shares for the 1 ^ shares of new Prior Pref- 
erence stock for which the present Preferred stock may be exchanged. Thus, 
holders of Preferred stock who make the exchange will place themselves in a 
position to participate in the future earnings of the company as Common stock- 
holders by converting the new Prior Preference stock into Common stock. 



American Woolen Company 253 

Upon consummation of the Plan it is intended to pay promptly the dividend 
accumulation on any unexchanged Preferred stock. 

A vote in favor of the Flan does not in any way commit a Preferred stock- 
holder to make the exchange. It is intended that, following approval of the Plan 
and completion of registration, the exchange offer v^^ill be made to holders of 
Preferred stock for a limited period, but acceptance or rejection of the offer will 
be entirely optional with the stockholder. 

The Plan in Relation to Common Stockholders 

The Common stockholders now own the entire equity of the company sub- 
ject to the preferences of the Preferred stock, including the dividend accumula- 
tions thereon. However, these preferences are so large that no dividends have 
been paid on the Common stock since 1924 and no dividends can be paid under 
the present capital structure until the present dividend accumulations of 
$20,475,000 have been eliminated. Currently the regular dividend upon the Pre- 
ferred stock is being earned by a wide margin but the average annual earnings of 
the company and its predecessor since 1899 have been only slightly in excess of 
the present annual dividend requirement upon the Preferred stock. 

It is impossible to determine how much of the Preferred stock may be ex- 
changed pursuant to the Plan but, to the extent that exchanges are made, the 
dividend accumulations on such stock will be eliminated and the annual dividend 
requirement will be reduced by $1 for each share exchanged. To the extent that 
any new Prior Preference stock may subsequently be converted into Common 
stock, the amount of Common stock outstanding will be increased at the rate of 
2 shares for each share of Prior Preference stock so converted, but this would be 
accompanied by a proportionate decrease of senior capital now coming ahead of 
the Common stock. 

Upon consummation of the Plan the company intends to pay promptly the 
accrued dividends on the unexchanged Preferred stock and to initiate dividends 
on the Common stock. The rate and continuity of Common stock dividends will 
obviously depend on the trend of earnings but, if the Plan is consummated, the 
Directors expect to pay dividends on the Common stock of at least $5 a share 
in 1946. 



Conclusion 

After a careful study, the Directors believe that the proposed Plan is in the 
interests of holders of both classes of stock and recommend that all stockholders 
vote in favor of the Plan. 

Adoption of the Plan will require the affirmative vote of two-thirds of each 
class of stock outstanding. It is important, therefore, that every stockholder make 
sure that his stock is represented at the meeting by filling, signing and returning 
the enclosed Proxy promptly. 

[s] M. Pendleton 
"President 
June 3, 1946 



254 Case Problems in Finance 

The stockholders convened as scheduled on July 3, with results as 
described in the Commercial and Financial Chronicle of July 1 5 : 

The special meeting of stockholders called to act upon a plan of recapitaliza- 
tion was adjourned on July 3 for two weeks to July 17. Additional time is sought 
for further stockholder responses to the proposed Plan. 

Over 60% of the Common stock and over 75% of the preferred already have 
registered approval, it was said. 

Moses Pendleton, President, stated the Plan would automatically go into ef- 
fect when holders of 80% of Preferred have deposited their stock and registered 
their approval of the Plan. He also said that the company is operating at capacity. 
Terming earnings highly satisfactory, he said that unaudited profits for the first 
five months of the year, were at a somewhat better annual rate than reported for 
the first quarter. 

Unfilled orders on June 1 were $62,000,000 or almost equivalent to the war- 
time volume of a year ago. 



American Woolen Company 



255 



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256 Case Problems in Finance 

Exhibit 2 

AMERICAN WOOLEN COMPANY 

Balance Sheet, December 31, 1945 

(Dollar figures in thousands) 

ASSETS 

Cash $ 23,926 

U.S. government securities at cost 5,100 

Accounts receivable — net 1 1,594 

Inventories 37,701 

Other current assets 1,636 

Total current assets $ 79,957 

Inventory in subsidiary 9 

Fixed assets — net 22,861 

Other assets 1,510 

$104,337 

LIABILITIES 

Accounts payable — trade % 828 

Accrued liabilities 3,202 

Reserve for federal income taxes 19,361 

Reserve for renegotiation refunds 700 

Other current liabilities 777 

Total current liabilities $ 24,868 

3i% mortgage on real estate 940 

Special reserve for war contingencies 9,000 

7% preferred stock — 350,000 shares outstanding* 35,000 

Common stock — 400,000 shares — no par at $5.00, stated value . . 2,000 

Capital surplus 2 1,290 

Earned surplus since January 1, 1941 11,239 

$104,337 

* Preferred arrearages to date are $20,562,500, or $58.75 per share. 



^\\vvv^^vvwwvvlA\vv^\vvvv\vv^vw^/\Avv\^vv\vvvv^AA/wvvv^^ 



Ohio Gauge Company 



V\AVV\VtVVV\VVVVVVVV\VWVVV\VVVVVVVVVV\VVVWVVVVVVVW\VV\^^ 

In November, 1945, Robert Shea, aged 44, president and principal 
stockholder of the Ohio Gauge Company, was contemplating the issu- 
ance of common stock for the purpose of retiring the company's remain- 
ing preferred stock. 

Mr. Shea had first become acquainted with the Ohio Gauge Com- 
pany in October, 1932, when he bought several hundred shares of its 
common stock. At the time, Mr. Shea was assistant to the president of 
National Shares, Inc., an investment trust located in New York City. 
Mr. Shea also engaged in speculation on his own account. He had 
bought his Ohio Gauge Company shares on the recommendation of a 
friend, William Hewitt, a securities salesman in the small Wall Street 
brokerage and investment banking firm of Sutcliffe and Company. 
Mr. Hewitt, a native of Springdale, Ohio, the city in which the Ohio 
Gauge Company was located, and a nephew of the company's treasurer, 
was intimately acquainted with its affairs. Mr. Hewitt was of the opinion 
that the stock was undervalued at its current over-the-counter price of 
If, which compared with a 1929 high of 25^, and had great potential 
"leverage" because of its low price and because of dividend arrearages 
which had been accumulating on an issue of $8.00 preferred stock since 
1930. In the event of a general stock market rise Mr. Hewitt believed 
that the price of the Ohio Gauge Company's common stock would in- 
crease at a greater rate, percentagewise, than the stock market averages. 
Accordingly, he had bought several hundred shares and was advising his 
close friends and customers to do likewise. 

Several months later Mr. Shea became curious about the company, 
looked up its financial record, and made some inquiries. Among the 
things he learned was that the Mammoth National Bank of New York 
owned a controlling interest in the company, which it had acquired in 
1930 as collateral on a defaulted loan to a Cleveland brokerage firm. 

257 



258 Case Problems in Finance 

The bank had been instrumental in getting several new directors 
elected and was trying to straighten out the company's affairs but was 
not meeting with much success. 

The thought came to Mr. Shea that he could probably purchase the 
bank's interest at less than the current over-the-counter price of 2 J be- 
cause the bank would be glad to rid itself of the responsibility of man- 
aging an industrial company and because it could not hope to sell its 
shares without causing the price to break sharply. Once he had control 
Robert Shea thought he could persuade the preferred stockholders to 
consent to a recapitalization which would eliminate the accumulated 
arrears on the $8.00 preferred, thereby enhancing the prospects of pay- 
ing dividends on the common stock. Such a move, he thought, would 
raise the price of the common stock substantially, enabling him to sell 
his holdings at a good profit. 

Mr. Shea had learned that the Mammoth National Bank owned 
about 50,000 of a total of 1 16,000 outstanding shares of common stock. 
Since no other group owned as much as 10% of the stock, the Mam- 
moth National Bank block was the controlling interest. Because of 
arrearages on the $8.00 preferred, each of the 22,940 preferred shares 
outstanding was entitled to four votes. The preferred stockholders had 
not organized, however, and Mr. Shea did not believe that they would 
endanger the success of his plan. 

Mr. Shea thought that he could drive a hard bargain with the bank. 
He knew that no bank liked to find itself responsible for the manage- 
ment of an industrial company. He also believed that no one else had 
made an offer for the stock and that only a small number of shares could 
be absorbed by the market without causing a precipitate price decline. 
Under the circumstances, and in view of a current over-the-counter price 
of 2i and a 1932 low of 1, he thought that he would offer 1^ for the 
stock, with the aim of settling for 1^. 

Mr. Shea discussed his plans with a few close friends and persuaded 
them to share in the venture. He himself intended to put $50,000 into 
the speculation, half of which amount he expected to borrow using the 
stock as collateral. William Hewitt was invited to participate but de- 
clined on the grounds that he lacked available funds. 

The bank proved even more receptive than had been anticipated, 
and the 50,000 shares were obtained in July of 1933 at 1|, or a total of 
$68,750. Shortly thereafter Mr. Shea was elected to the board of direc- 
tors. Operation of the company was left in the hands of the existing 



Ohio Gauge Company 259 

management while Mr. Shea concentrated on devising a plan of re- 
capitalization. What he wanted was a plan that would eliminate the 
arrearages and modify the cumulative provisions of the preferred stock 
without materially diluting the common stockholders' equity. 

Mr. Shea was aided by the fact that the Ohio Gauge Company had 
been incorporated in Massachusetts because of the comparatively liberal 
corporation laws of that state. Under Massachusetts' law a corporation 
could alter "the classes of its capital stock subsequently to be issued and 
their preferences and voting power, or make any other lawful amend- 
ment or alteration in its agreement of association or articles of organiza- 
tion by vote of two-thirds of each class of stock entitled to vote, or by a 
larger vote if the agreement of incorporation so required." The com- 
pany's Agreement of Incorporation, in which were included the authori- 
zation and provisions of the preferred and common stocks, contained a 
similar clause. Mr. Shea wanted to take advantage of the law to create 
a new class or classes of preferred stock which would rank prior to the 
$8.00 preferred. The new stock would be offered to the $8.00 preferred 
stockholders for voluntary exchange. By making the recapitalization 
plan sufficiently attractive he hoped to get the required two-thirds of the 
$8.00 preferred stockholders to approve it. Once the plan was approved 
the dissenting stockholders would be under pressure to accept the ex- 
change because the $8.00 preferred stock would then be subordinate 
to the new stock. 

Mr. Shea discussed his plans with the company's counsel, the Cleve- 
land firm of Frobisher, Fitzwilliam, and Frost. The firm was unwilling 
to commit itself on whether the issuance of stock having priority over 
the $8.00 preferred, as contemplated by Mr. Shea, would be sanctioned 
by the courts. Moreover, the firm indicated that they thought that his 
proposal was inadvisable even if it were legal. In view of their attitude, 
Mr. Shea reluctantly revised his plan. The recapitalization plan finally 
decided upon in October, 1933, after considerable discussion with the 
principal preferred and common stockholders, was as follows: 

1. The following classes of stock would be created: 

a) $6.00 preferred stock with no par value which would be entitled to 
dividends when, as, and if declared by the Board of Directors at an 
annual rate of $6.00 a share. Such dividends would start in 1935 and 
would be cumulative only to the extent that they were earned in a 
given year. So long as any $8.00 preferred stock was outstanding, 
dividends (other than cumulative dividends) on the $6.00 and the 
$8.00 preferred stocks would not have preference over each other but 



260 Case Problems in Finance 

when, as, and if declared would be paid on a pro rata basis. The $6.00 
stock would be callable in whole or in part at 105 plus accumulated 
dividends and would be entitled to $100 a share plus accumulated 
dividends pro rata with the rights of the $8.00 preferred stock on 
liquidation or dissolution. Holders of the $6.00 preferred stock would 
be entitled to two votes for each share whenever dividends in the 
amount of $6.00 a share had not been paid in the preceding calendar 
year. 
b) $1.50 convertible preferred stock which would be subordinate in all 
respects to the $8.00 and the new $6.00 preferred and would be en- 
titled to noncumulative dividends of $1.50 a share when, as, and if 
declared, in preference to the common stock. Each share of $1.50 
preferred stock would be convertible at any time, prior to a date fixed 
for redemption and payment, into two shares of the common stock of 
the company as it might be at the time. The $1.50 convertible pre- 
ferred stock would be callable at $32 a share (the amount of divi- 
dends which would have accumulated on the $8.00 preferred at the 
time the plan became effective) and would be entitled to $32 a share 
in preference to the common stock in the event of liquidation or dis- 
solution. The stock would have no voting rights. 
2. One share of the new $6.00 preferred and one share of the new $1.50 
convertible preferred stock would be offered in exchange for each share 
of the $8.00 preferred stock and accumulated arrearages. 

Having arrived at a plan, Mr. Shea next set about winning the con- 
sent of the 900 preferred stockholders and the principal common stock- 
holders. The $8.00 preferred stock had been issued in 1923, with Sut- 
cliffe and Company acting as sole underwriter. Sutcliffe and Company- 
had lost interest in the company since the underwriting, and the firm 
was no longer represented on the board of directors and did not main- 
tain a market for the issue. Nevertheless, Sutcliffe and Company was 
asked to help contact the stockholders, and it consented to speak to all 
of its customers who held the $8.00 preferred. However, the firm did 
not act as vigorously as Mr. Shea would have liked. William Hewitt 
was active, but it was largely on his own initiative and without en- 
couragement from his employers. Mr. Shea also enlisted the assist- 
ance of a Cleveland securities firm, Forbes, Knox and. Company. James 
Stuart, a trader and salesman in the latter firm, was especially active in 
Mr. Shea's behalf. Forbes, Knox and Company was able to pick up a 
substantial number of trading commissions by persuading doubtful 
stockholders to sell their shares and then reselling them to the firm's 
customers. Mr. Shea and his associates were also active, taking time off 
from their work to visit and correspond with individual stockholders. 



Ohio Gauge Company 261 

In speaking with the preferred stockholders Mr. Shea emphasized 
the fact that there was little prospect of ever being able to pay in full 
the accumulated arrearages on the $8.00 preferred, thereby opening the 
way for resumption of common stock dividends. So long as this unfavor- 
able prospect existed, he stated, management would have no incentive 
for paying anything on the preferred stock and would retain all earnings 
in the business. On the other hand, if the proposed plan were to go 
through, he promised that management would pay whatever dividends 
were earned on the preferred so as to leave the way open for resumption 
of common stock dividends at the first opportunity. 

In his talks with the principal common stockholders Mr. Shea 
pointed out the advantages to them of eliminating the arrears and modi- 
fying the cumulative provisions of the preferred stock. He also empha- 
sized the dangers inherent in the possibility of organized action by the 
preferred stockholders, especially in view of the $8.00 preferred stock's 
four-for-one voting power. As a result of the combined efforts of Mr. 
Shea, his associates, and the two securities firms, holders of 95% of the 
preferred stock and more than the required two-thirds of the common 
stockholders agreed to the recapitalization plan at a special stockholders' 
meeting in March, 1934. 

While Mr. Shea had been working on the recapitalization plan, 
word of his activities had gotten around and the price of the common 
stock had gone to 6. No significant increase in price had occurred, how- 
ever, after the plan had been officially accepted and put into effect ( see 
Exhibit 1 [p. 270}). There was little interest in the stock, and its 
market remained "thin," with only a few hundred shares being traded 
each week. Mr. Shea and his associates realized that they would be un- 
able to sell their shares without causing a ruinous price break. As a 
result, they were forced to hold their stock for the time being. 

Profits were earned in 1935 and subsequent years. (See Exhibit 2.) 
True to Mr. Shea's promise to the preferred stockholders, 60% of the 
1935 earnings were paid out as dividends, amounting to $3.00 a share 
on the $8.00 preferred and $2.25 a share on the $6.00 preferred. The 
regular $6.00 dividend, plus arrearages accumulated in 1935, was paid 
the following year and every year thereafter except in 1938, when earn- 
ings amounted to less than $0,004 a share on the $6.00 preferred, and 
dividends were omitted. Dividends were not paid on the $1.50 con- 
vertible preferred, which had no cumulative provisions of any sort until 
1940, even though earnings had been available for such payment in 



262 Case Problems in Finance 

prior years. Starting with 1940 the regular $1.50 dividend was paid each 
year. Dividend payments were resumed on the common stock in 1940 
also. Cash payments on the latter were as follows: 

1940 $0.50 a share 

1941 1.00 a share 

1942 1.00 a share 

1943 0.50 a share 

1944 0.25 a share 

1945 0.60 a share 

In addition, 5% stock dividends were paid in both 1944 and 1945. 

It was apparent to Mr. Shea and his associates when they decided in 
1934 to continue holding their stock that they would have to strengthen 
the company's management in order to safeguard their investment. The 
management had never been outstanding, and the fierce competition 
characteristic of the depression had emphasized its shortcomings. More- 
over, the company's plant and equipment were outmoded. For a number 
of years prior to 1930 the controlling stockholders, in order to conserve 
money for the payment of dividends, had prevented management from 
spending sufficient money on buildings and machinery. These stock- 
holders had pledged their shares as collateral to finance personal specu- 
lations and a substantial price decline would, and in 1930 did, wipe 
them out. By continuing to pay dividends they had hoped to keep the 
price of the common stock from falling. As a result of its outmoded 
equipment, the company's production costs were relatively high. The 
sales organization also compared unfavorably with its competitors, 
chiefly because its best men had left in 1929 when drastic salary cuts 
were resorted to as a means of conserving cash. 

Mr. Shea had thought that he would be able to straighten out the 
company's affairs in his spare time. Establishing the company on a 
sound operating basis, he had hoped, would raise the price and broaden 
the market for its common stock. Management by remote control proved 
unfeasible, however. By 1936 it had become apparent that rehabilitation 
of the company was going to be a long-run, full-time job. At the same 
time that Mr. Shea was coming to this realization, he was becoming 
dissatisfied with his position at National Shares, Inc. The latter's presi- 
dent had died in 1935 and Mr. Shea found himself out of sympathy with 
his successor's personality and policies. For these reasons, Mr. Shea, in 
1936, decided to resign his Wall Street position to become president of 
Ohio Gauge Company. The latter position paid an annual salary of 
$35,000, almost twice what Mr. Shea had received from National 
Shares, Inc. 



Ohio Gauge Company 263 

Mr. Shea soon learned that he had tackled a difficult job. The com- 
pany was the principal employer in the town of Springdale, and the 
townspeople felt that they had a vested interest in the company's affairs. 
Mr. Shea found that it would not be politic to discharge a number of 
men whom he would have liked to replace. Instead, he had to devise 
new titles and to reallocate duties so as to create an organization with 
which he could be satisfied. Mr. Shea also encountered a great deal of 
difficulty in finding the right men for his organization. Mistakes were 
made and turnover of executive personnel was high. Nevertheless, some 
progress was achieved in the direction of improving sales and production 
and in replacing outworn and outmoded machinery. One of the steps 
taken shortly after Mr. Shea became president was to engage a New 
York law firm as counsel in place of Frobisher, Fitzwilliam, and Frost. 

Following the 1934 recapitalization about half of the dissenting 
$8.00 preferred stockholders converted their shares. The remaining 
stockholders continued to hold out in expectation that the arrearages 
would eventually be paid in full so as to open the way for resumption of 
common stock dividends. Mr. Shea was determined not to pay the ar- 
rearages, however, because he felt that this small group was trying to 
profit at the expense of the other stockholders. Passage of the undistrib- 
uted profits tax in 1936, however, enabled the company to effect a sub- 
stantial tax saving by paying the accumulated dividends, so that Mr. 
Shea reluctantly agreed to do so. The shares still outstanding were called 
at the redemption price of $1 10 a share shortly thereafter. 

By 1936 financial pressure on the company had slackened. At the 
time, the $6.00 and $1.50 preferred stocks were being quoted over the 
counter at a fraction of their call price (see Exhibit 1 ) . Mr. Shea was of 
the opinion that it would be to the advantage of the common stockhold- 
ers to purchase as much of the $6.00 preferred stock at current prices as 
the company could afford. Mr. Shea called James Stuart, whose work 
in winning consent to the 1934 recapitalization had impressed him 
favorably, and asked him to buy as much of the $6.00 preferred stock 
for the company's account as could be obtained at current prices. It was 
found, however, that only a relatively small number of shares could be 
obtained at quoted prices. The majority of the holders had owned the 
$8.00 preferred, for which they had paid a good price, and they were not 
interested in selling at a discount. In all, less than 1,000 shares of $6.00 
preferred had been purchased up to the recession of late 1937, at which 
time Mr. Shea decided to discontinue the company's stock purchases in 
order to conserve cash. 



264 Case Problems in Finance 

From time to time, shares of the $1.50 preferred were converted. 
These conversions were usually connected with arbitrage transactions. 
As a rule, the price of the $1.50 preferred was twice the price of the 
common stock. From time to time, however, the price would fall below 
the 2 : 1 ratio. At such times some dealers would seek to make a profit 
by buying the preferred, converting it into common stock, and reselling 
the latter. Over 9,000 shares of the $1.50 preferred were converted in 
the period from 1934 to 1943. 

In the fall of 1937, when security prices were reaching post-depres- 
sion highs, Ohio Gauge common stock was quoted at 16^. The market 
for the stock remained thin, however, with weekly sales averaging 500 
shares. When security prices fell in the latter part of the year average 
weekly sales rose to about 1,600 shares and the price was forced down 
to 4, a far greater percentage drop than was characteristic of the market 
as a whole. 

In 1939 several European governments sent missions to the United 
States for the purpose of purchasing a variety of products, including 
gauges, to be used in preparing for the war which seemed imminent. 
Mr. Shea actively bid for such orders and was successful in obtaining a 
number of contracts. When war did break out in Europe, Mr. Shea 
anticipated that the United States would become involved eventually 
and that, in his words, a "bull market" in machine tools would follow. 
Accordingly, orders were placed for new machinery and the organization 
was geared for large-scale expansion. 

When the United States embarked on a major defense program in 
1940, Mr. Shea concentrated on obtaining government contracts. He 
soon succeeded in getting on favorable terms with the officials respon- 
sible for placing orders, and he co-operated with them fully in ex- 
pediting production. In many instances he proceeded to make commit- 
ments for materials and for new equipment on the strength of verbal 
agreements made many months before written contracts were received. 
Due to Mr. Shea's efforts the company was well ahead of its com- 
petitors in percentage sales increase during the war. Symbolical of its 
leadership is the fact that it was among the first to win the Army- 
Navy "E." 

Financing a greatly increased volume of business strained the com- 
pany's financial resources. In November, 1940, an Emergency Plant 
Facilities contract was entered into whereby the company undertook to 
build and equip a new micrometer plant, for which the government was 
to reimburse it to the extent of 85% of cost. Total cost amounted to 



Ohio Gauge Company 265 

$875,000 and was financed by a bank loan until reimbursement was 
received. In 1942 a contract was signed whereby the company was 
authorized to purchase up to $1,000,000 of equipment as agent for the 
Defense Plant Corporation. Payment was made by the Defense Plant 
Corporation direct to the seller. Some $900,000 of equipment was pur- 
chased under this contract, on which the company paid an annual rental 
of 12% of cost. At the end of the war, management expected to pur- 
chase the micrometer plant, and such of the equipment acquired under 
the Defense Plant Corporation contract as it could use, at about one- 
third of original cost. The company also purchased $1,060,000 of equip- 
ment on Certificates of Necessity from 1940 to September, 1945. These, 
in accordance with Treasury Department regulations, were amortized 
at an annual rate of 20%, and the unamortized portions were fully 
amortized on September 30, 1945, in accordance with the President's 
Proclamation of September 29, 1945. 

Toward the end of 1941, bank loans, exclusive of loans for the con- 
struction of the micrometer plant, totaled $550,000 and Mr. Shea was 
greatly concerned about the likelihood that the growing volume of 
business would necessitate even greater borrowing. In 1942, however, 
advances totaling about $2,000,000 were received from the govern- 
ment and the bank loans were liquidated. Another unlooked for source 
of cash was accrued taxes. From 1942 through 1944 taxes payable 
ranged from about $1,500,000 to about $3,400,000. 

When it became apparent to Mr. Shea in 1943 that the war years 
would be highly profitable and that the company would be in possession 
of cash in excess of its operating needs, he decided that the time had 
come to think seriously about eliminating the preferred stock. Under 
prewar conditions payment of preferred dividends had left little or no 
earnings for the common stock. Moreover, since the $6.00 preferred 
dividends were cumulative only to the extent earned, and since man- 
agement did not wish to pay unearned dividends on the preferred stock, 
it had to wait until the end of each year before declaring any dividends 
on the common stock. Mr. Shea believed that placing the common stock 
on a quarterly dividend basis would enhance its appeal to investors. 

The $1.50 convertible preferred was currently being quoted at 
around 14 and the $6.00 preferred at around 53. Mr. Shea decided that 
the company should resume the practice of buying its preferred stock 
on the open market, with a view toward acquiring as many shares as 
possible of the two issues. 

In order to raise additional funds for this purpose it was decided to 



266 Case Problems in Finance 

take advantage of wartime increases in industrial property values to sell 
several small branch plants which had proved uneconomical. About 
$250,000 was realized from these sales. Another $50,000 was raised 
through the sales of the company's Cleveland warehouse, which had 
been carried on its books at a value, after depreciation, of $400,000. 
The loss on the sale was deductible for tax purposes. The space oc- 
cupied by the company was subsequently leased from the new owner 
at a rental far below the previous annual charges. 

Early in 1943, Mr. Shea instructed James Stuart, who had left the 
employ of Forbes, Knox and Company to accept a partnership in the 
Cleveland brokerage and investment banking firm of Willing, Smith 
& Westerly, to buy as many shares of the $1.50 and $6.00 preferred 
stock as could be obtained without materially influencing the price. 
Mr. Shea was willing to pay up to $16 a share for the $1.50 issue and 
up to $60 a share for the $6.00 preferred. These amounts were subse- 
quently raised as the over-the-counter price of the stock increased (see 
Exhibit 1 ) . It was found, however, that only a relatively small number 
of shares could be purchased at the prices at which the stocks were being 
quoted over the counter. In order to encourage selling, Mr. Stuart pre- 
pared a schedule of selected preferred stocks which had higher yields 
than the Ohio Gauge shares. Willing, Smith & Westerly sent this 
schedule to a list of stockholders obtained from the company's registry 
records, hoping that a large number would be persuaded to sell their 
Ohio Gauge shares and to buy the issues recommended in the schedule. 
The maneuver did not prove effective, however. In all, less than 3,500 
shares of $6.00 preferred and 2,700 shares of $1.50 preferred were 
purchased between January, 1943, and June, 1945. In the latter month 
it was decided to ask for tenders from the $6.00 preferred stockholders. 
At the time, the stock was being quoted at about $82 a share. The stock- 
holders' response proved disappointing, however. Only a few hundred 
shares were offered at less than 90, the maximum which Mr. Shea was 
willing to pay, and only a few hundred more were offered at less than 
the call price of 105. 

After V-J Day, in August, 1945, Mr. Shea decided to use the funds 
accumulated during the war to call half the 16,000 shares of $6.00 
preferred stock still held by the public. Redemption of the shares was 
voted by the directors and notice sent to the holders, late in August. In 
September of 1945 the price of the common stock, which had long been 
quoted at about the value of its net working capital, began to increase 



Ohio Gauge Company 267 

and by October had reached a high of 20 (see Exhibit 1 ) . Mr. Shea saw 
in this increase an opportunity to eliminate the $1.50 preferred without 
cash expenditure by caUing the issue and thereby forcing conversion. 
He was concerned, however, by the possibility that the common stock 
might fall between the time the directors voted to redeem the $1.50 
preferred and the redemption date. In order to minimize such risk it was 
decided to give only 15 days' notice of redemption. Before the re- 
demption was voted, a questionnaire was sent to the shareholders in- 
forming them that the company was contemplating calling the issue 
and asking them whether they would convert their stock on receiving 
notice of such redemption. The principal purpose of the questionnaire 
was to get the stockholders to make their decision beforehand, so that 
they would act quickly after receiving their notice. Replies were re- 
ceived from about two-thirds of the stockholders, an unusually large 
response. Virtually all indicated that they would convert their shares in 
the event the issue was called. The redemption was voted and notice 
sent to the stockholders on November 15, 1945. At the same meeting 
the directors declared a $0.60 per share dividend on the common stock 
payable to stockholders of record on November 30, the last day on 
which the $1.50 preferred could be converted. With the exception of a 
few stockholders who failed to present their shares either for redemption 
or conversion and a few who evidently didn't understand much about 
securities, all the $1.50 preferred stockholders converted their shares 
prior to the November 30 deadline. 

Mr. Shea next turned his attention to the task of eliminating the 
remainder of the $6.00 preferred. During the war he had several times 
discussed with his friend William Hewitt, who was now a partner in 
Sutcliffe and Company, the possibility of issuing common stock as a 
means of providing funds for redeeming the preferred. Now that the 
price of the common stock had passed 20 he felt that it was time to give 
serious consideration to such a step. While on a business trip to New 
York late in November, Mr. Shea called on Mr. Hewitt and asked him 
whether he had been serious when he had last spoken about under- 
writing an issue of the Ohio Gauge Company common stock. Mr. 
Hewitt replied that he certainly had been and that this looked like a 
good time to do it. Mr. Shea then asked if there would be "room" in 
the underwriting syndicate for Willing, Smith & Westerly and was as- 
sured that there would be. 

One of his aims in the event a public issue was decided upon, Mr. 



268 Case Problems in Finance 

Shea informed Mr. Hewitt, would be to broaden the market for the 
company's stock. Mr. Hewitt rephed that his firm, and the members 
of the selling group to be formed, could make an effort to distribute the 
issue as widely as possible. Some selling agreements, he informed 
Mr. Shea, provided that the participants would endeavor not to sell or 
allot to any one customer more than a given number of shares. Wide 
distribution, Mr. Hewitt added, not only would broaden the market for 
the issue but would also minimize the risk that some group might pur- 
chase enough stock to challenge Mr. Shea's control of the company. 

Mr. Hewitt also suggested that the issue be listed on the New York 
Stock Exchange as a means of adding to the company's prestige and 
broadening the market for its stock. He pointed out that many investors 
and investment counselors favored listed securities because it was be- 
lieved that they could be sold more readily, in an emergency, than could 
unlisted securities. 

Mr. Shea questioned the value of listing on the exchange, however. 
People, he said, didn't buy securities because they were listed on the 
Stock Exchange; they bought them because they thought that they 
would go up in price. Many unlisted securities, he pointed out, had a 
high turnover, while a number of listed securities were traded only infre- 
quently. Moreover, listing on the exchange would place the issue under 
the Securities Exchange Act of 1934. This act, Mr. Shea reminded 
Mr. Hewitt, required additional periodic reports which were not called 
for by the Securities Act of 1933. Mr. Shea called especial attention to 
Section l6a of the 1934 act which required holders of more than 10% 
of any listed security and officers and directors of issuers of a listed secu- 
rity to report any changes in their holdings. 

The price at which the issue would be sold to the public would be 
determined by the price at which the common stock was selling at the 
time of filing the price amendment to the registration statement required 
by the Securities and Exchange Commission. This amendment would 
be filed within 24 hours before the registration of the issue was sched- 
uled to become effective. 

While discussing the underwriting fee that his firm would receive, 
Mr. Hewitt said that the average fee for comparable issues floated dur- 
ing the past few months would be acceptable. This average amounted 
to about 8% of the selling price. Mr. Shea argued that the fee should 
be less than average, however, because of their close relationship. He 
expressed the fear that other stockholders might claim that the com- 



Ohio Gauge Company 269 

pany could have gotten a better deal by shopping around and that a 
smaller than average fee would forestall any such accusations. After 
some discussion Mr. Hewitt agreed, subject to the approval of his part- 
ners, to accede to his friend's wishes on this point. 

Mr. Hewitt recommended that the preparation of the registration 
statement required by the Securities and Exchange Commission be 
started immediately so as to enable the company to offer the issue as 
soon as possible, thereby minimizing the risk of a decline in the com- 
mon stock's price before the offering date. The registration statement 
would require, among other information, recent audited statements. 
Mr. Hewitt suggested that the company's public accountants be en- 
gaged to prepare statements as of November 30, 1945. Mr. Shea, how- 
ever, indicated that he would prefer to wait for the regular year-end 
audit. December, he anticipated, would be a profitable month, and he 
would like to have it included in the prospectus. Moreover, he said that 
he had a hunch that the market was going up during the next few 
months, so that it would be to the company's advantage to wait. 

At the conclusion of his talk with Mr. Hewitt, Mr. Shea said that 
he would like to give further thought to the matter. He had some 
doubts as to whether $22 a share, at which the common stock was cur- 
rently being quoted, was a fair price. He was also undecided about 
whether to list on the Stock Exchange and whether to wait for the 
regular year-end audit. 



Exhibit 1 



THE OHIO GAUGE COMPANY 
over-the-counter stock prices (bid) 

$1.50 Convertible 









Common 


Preferred 


$6.00 Preferred 








High 


Low 


High Low 


High 


Low 


1928 







...16 


9i 










. , 


1929 






...25i 


12 














1930 






...20 


6 














1931 






... 6 


U 














1932 






...21 


1 














1933 






... 6 


H 














1934 






...61 


5 














1935 






...lOi 


4i 


2U 


9i 


50 


29 


1936 






...lOi 


61 


201 


L4 


54 


44 


1937 






...16i 


4 


34 


8 


78 


26 


1938 






...81 


4i 


14 


7 


53 


28 


1939 






...lU 


Ah 


22 


9 


57 


32 


1940 






...lOS 


61 


20 


L4 


68 


48 


1941 






...lOi 


6i 


21 


L5 


69 


50 


1942 






... 7i 


5i 


16^ 


13 


584 


51 


1943 






...10 


5i 


18 ] 


L3 


57 


51 


1944 






...lU 


61 


23 ] 


L5 


78 


55 


1945* 







...24 


101 


40 22 


102 


71 


* To November 30 






















Exhibit 2 














OHIO GAUGE COMPANY 














Income Data 












(Dollar figures 


in thousands) 










Gross Sales — 


Cost of 




Net Income be- 








Less Discounts, 


Sales and 


Provision 


fore Taxes on 










Returns, and 


Selling and 


for 


Income and Provision 


Extraor- 




Allowances and 


Adminis- 


Depreciation 


Extraor- 


for 


dinary 




Calendar 


Renegotiation 


trative 


and Amor 




dinary Taxes on 


Deduc- 


Net 


Year 


Provision 


E:Kpenses 


fixation 


Deductions Income 


tions 


Income 


1928 


$ 3,027 














$410 


1929 


3,439 














502 


1930 


2,182 














124 


1931 


1,330 














68d 


1932 


883 




Data Not Available 






162d 


1933 


1,240 














12d 


1934 


1,74^ 














11 


1935 


2,555 














89 


1936 


3,223 


$ 2,735 


$133 




$ 355 $ 


v> 


$ 14* 


318 


1937 


4,198 


3,347 


122 




683 


69 , 




614 


1938 


2,563 


2,362 


136 




27 


1 


26* 


t 


1939 


3,464 


2,977 


138 




327 


68 




259 


1940 


5,094 


3,906 


217 




883 


402 




481 


1941 


10,232 


6,904 


368 




2,769 


1,854 


311t 


604 


1942 


16,458 


12,288 


432 




3,557 


2,719 


234t 


604 


1943 


17,361 


13,593 


483 




2,989 


2,271 


234t 


484 


1944 


13,827 


10,862 


534 




2,315 


1,752 


144t 


419 


1945 § 


11,967 


9,857 


368 




1,574 




1,205 




369 



* Flood expense. 

t Net income In 1938 was $71. 

X Provision for contingencies and postwar adjustments. 

J As estimated in November. 
Deficit. 



Dec. 31 

1944 


Sept. 30 
1943 


$1,904 


$1,658 


1,667 
1,467 


288 
1,094 
1,366 

231 


$5,038 


$4,637 


179 

34 

2,071 

$ 884 

636 


1,830 



Exhibit 3 
OHIO GAUGE COMPANY 

Balance Sheets 

(Dollar figures in thousands) 

ASSETS 

Dec. 31 Dec. 31 

Current assets: 1938 1941 

Cash $ 93 $ 15 

U.S. excess profits tax refund 

bonds — due 1/1/46 .... 

Accounts receivable, net 265 1,454 

Inventories 1,215 2,541 

Claim for refund of prior year's taxes .... 

Total current assets $1,573 $4,153 

Other assets'. 
Treasury stock: 

$6.00 preferred 

$1.50 preferred 

Net property, plant, and equipment ... 2,430 2,515 

Emergency plant facilities $ 849 

Less: Reserve for amortization 109 

Balance $ 740 $ 248 

Postwar refunds of excess profits 

taxes — estimated .... 394 .... 

Other assets 26 42 308 94 

Total assets $4,029 $7,450 $8,272 $6,561 



LIABILITIES AND CAPITAL 
Liabilities : 

Current liabilities : 

Notes payable to banks — emergency 

plant facilities .... $ 149 .... 

Notes payable to banks $ 239 $ 687 .... 

Accounts payable 68 522 299 $ 244 

Accrued expenses .... 87 99 

Accrued taxes 16 159 179 161 

Advance from U.S. government on 

contracts .... 270 .... 

Provision for federal income and ex- 
cess profits taxes 83^ 1,230 1,419 1,447 

Total current liabilities $ 406 $2,598 $2,403 $1,951 

Other liabilities: 

Notes payable to banks — emergency 

plant facilities 661 175 .... 

Reserve for postwar contingencies 

and adjustments 90 810 810 

Total liabilities $ 406 $3,349 $3,388 $2,760 

Capital : 

Capital stockf $2,931 $2,931 $2,918 $1,741 

Surplus 692 1,170 1,966 2,060 

Total capital $3,623 $4,101 $4,884 $3,801 

Total liabilities and capital .$A,029 $7,450 $8,272 $6,561 

* Not audited. 

t Number of shares: 

$6.00 preferred— no par 20,700 20,700 20,296 8,000 

$L50 preferred— no par 16,074 12,817 12,216 

Comn:ion stock— no pari 125,985 131,104 138,341 166,068 

1 Common stock was sold to officers and employees under a stock-purchase plan. 



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La France Industries 



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The parts of this case are: 

1. Summary of corporate history. 

2. Description of the proposed plan of reorganization, excerpted 
from SEC Reorganization Release No. 16, dated September 1, 1939. 

3. SEC findings as to the fairness and feasibility of the plan, quoted 
( without footnotes ) from the SEC release. 

PART 1 

On July 11, 1939, the District Court of the United States for the 
Eastern District of Pennsylvania referred to the Securities and Exchange 
Commission a proposed plan of reorganization for La France Industries 
and its wholly owned subsidiary, the Pendleton Manufacturing Com- 
pany. The plan, which had been approved informally by protective 
committees representing the mortgage bondholders and other creditors, 
had been submitted by the debtor. Under the provisions of Chapter X 
of the Bankruptcy Act, it was the duty of the Securities and Exchange 
Commission to render an opinion on the fairness and feasibility of the 
plan. 

In normal years the two companies manufactured a substantial 
part of the upholstery fabrics produced in the United States. They 
also manufactured rugs and miscellaneous textile products. The weav- 
ing of these fabrics was done in a plant owned by the Pendleton Manu- 
facturing Company at La France, South Carolina, and the dyeing and 
finishing processes were carried out in the plants of La France Industries 
in the neighborhood of Philadelphia. A Canadian subsidiary operated 
a plant at Woodstock, Ontario. 

The financial difficulties of the companies became acute in 1936; 
La France Industries filed a voluntary petition in bankruptcy in July 
of that year, and the Pendleton Manufacturing Company filed a sim- 

272 



La France Industries 273 

ilar petition in September. The court appointed as trustee for both 
companies a man who had had no previous connection with either com- 
pany. By 1939 it was seen that the trusteeship had been more than 
ordinarily efficient in instituting economies and holding the trade posi- 
tion of the companies during a period of good volume of business for 
firms in the industry. 

During the progress of the trusteeship, certain claims were deter- 
mined by suit or by stipulation. Thus by July, 1939, the obligations that 
were to be dealt with in the reorganization were definitely known. These 
obligations, exclusive of those created by the trustee, are shown in Ex- 
hibit 1 (p. 274). 

Profit and loss statements for the combined companies for the years 
1933 through 1938 are shown in Exhibit 3 (p. 276). 

A description of the plan of reorganization is quoted below. The 
proposal has been tabulated in Exhibit 2 (p. 275 ). In Exhibit 4 is pre- 
sented a pro forma balance sheet giving effect to the proposed plan 
(p. 277). 

PART 2 

The plan provides for the transfer of all the assets of Pendleton to 
La France Industries and for the dissolution of Pendleton. The Cana- 
dian subsidiary will continue as a wholly owned subsidiary of the re- 
organized company. 

The securities to be issued under the proposed plan of reorganiza- 
tion are: 

1st mortgage RFC loan ( 5% ) $600,000 

2nd mortgage 4% bonds 731,250 

Certificates of indebtedness 173,735 

6% preferred stock 877,500 

Common stock 194,168 shares 

A. DESCRIPTION OF THE NEW SECURITIES 

The first mortgage obligation will be issued to the Reconstruction 
Finance Corporation in the principal amount of $600,000. The loan is 
to bear interest at 5 % and is to mature in 10 years, with amortization of 
not less than $60,000 annually. If earnings [after interest and taxes 
but before depreciation} exceed $120,000 annually, then one-half of 
such earnings are to be applied to amortization. 

This loan is to be secured by: a first mortgage upon all of the fixed 
assets of the reorganized company; a pledge of all of the common stock 



274 Case Problems in Finance 

of the Canadian subsidiary; an assignment of certain insurance policies 
on the Hfe of Bernard Davis, in the face amount of $500,000; and an 
assignment of the net proceeds of any recovery, to the extent of the un- 
paid balance of this loan, from [a suit against certain former directors 
of the company]. 

The new second mortgage bonds are to bear interest at 4%, mature 
in 15 years, and be secured by a lien, junior to that of the RFC, on the 
fixed assets and the proceeds of the lawsuit. The bonds are also [to be} 
secured by a first lien on $ 1 ,000,000 of insurance on the life of Davis, 
which now secures the present first mortgage bonds; this is insurance 
other than that which will secure the RFC first mortgage. The stock 
of the Canadian subsidiary is expressly excluded from the lien of this 
mortgage. 

While the RFC loan is outstanding, the second mortgage bond- 
holders cannot foreclose their lien on the fixed assets in the event of any 
default, regardless of its nature. This prohibition applies whether or 
not the RFC loan is in default. Sinking fund payments are to become 
operative only after the complete repayment of the RFC loan. Such 
payments on the bonds are to be $60,000 annually or one-half of net 
profits before depreciation, whichever is greater, except that the board 
of directors may limit the maximum to $60,000. [Net profits are de- 
fined as net earnings after interest and taxes but before depreciation.} 
The sinking fund may be used to purchase bonds at a price not exceed- 
ing 102 or to retire them by lot at 102. The bonds are convertible into 

Exhibit 1 
LA FRANCE INDUSTRIES AND PENDLETON MANUFACTURING COMPANY 

Obligations as Determined for Proposed Reorganization 
(Dollar figures in thousands) 

Taxes accrued before trusteeship $ 24 

Mortgage of La France Industries on one plant: 

Principal $ 60 

Accrued interest 2 62 

First mortgage bonds of La France Industries: 

Principal $1;463 

Accrued interest 292 1,755 

Unsecured claims: 

La France Industries $ 246 

Pendleton Manufacturing Company 116 362 

Total claims $2,203 

Common stock of La France Industries 164,918 shares 

Source: SEC Corporate Reorganization Release No. 16, September 1, 1939. 



La France Industries 



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Case Problems in Finance 



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La France Industries 277 

Exhibit 4 

LA FRANCE INDUSTRIES 

Pro Forma Balance Sheet, Giving Effect to the Merger with 

Pendleton Manufacturing Company and to the Proposed 

Reorganization, as of March 31, 1939 

(Dollar figures in thousands) 

ASSETS 

Cash $ 209 

Accounts receivable 561 

Inventories 1,241 

Current assets $2,01 1 

Cash value of life insurance 110 

Prepaid and deferred charges 105 

Stock of Canadian subsidiary 303* 

Land and plant, less depreciation 2,045t 

$4,574 

LIABILITIES 

Accounts payable, etc $ 254$ 

RFC loan due within one year 60 

Current liabilities $ 314 

Balance of RFC loan 540 

Second mortgage bonds 731 

Certificates of indebtedness 174 

6% preferred stock (par $100) 878 

Common stock (no par; 194,168 shares) 874 

Surplus 1,063 

$4,574 

* Valuation stipulated by parties to the reorganization. 

t An estimate of reproduction cost new, less depreciation. 

X Trustees' current liabilities and accrued taxes assumed by the new company. 

Source: Moody's Industrials, 1939. 

preferred stock at the rate of one share for each $100 principal amount 
of bonds. 

The certificates of indebtedness are unsecured, have no fixed matu- 
rity, and are to be paid only out of earnings. The following amounts are 
to be set aside for that purpose: (1) so long as the RFC loan is out- 
standing, 25% of the amount by which net earnings (after interest 
and taxes but before depreciation) exceed $120,000; (2) after retire- 
ment of the RFC loan, {at least} 50% of such net earnings but no 
more than the amount by which such earnings exceed $60,000. Interest 
of 4% on these certificates is to run only from the date of repayment 
of the RFC loan. 

The new preferred stock is to have a par value of $100. Cumulative 
dividends at the rate of 6% are provided. By the terms of the RFC 
loan, however, no dividends can be paid during the life of the loan, 



278 Case Problems in Finance 

so that by the terms of the plan, dividends will . . . accumulate dur- 
ing that period. [The stock will be callable after payment of the RFC 
loan at 105 and accrued dividends.} 

The common stock is to receive no dividends until the RFC loan, 
certificates of indebtedness, and accumulated preferred stock dividends 
have been paid in full. Thereafter, only 10% of the net income other- 
wise available for dividends on common stock may be paid as a dividend 
until the new [second mortgage] bonds are retired. After the bonds are 
retired, 25 % of such net income may be paid as common stock dividends 
until the preferred stock is retired. 

Voting control is to continue to reside with the common stock- 
holders, but, under the terms of the RFC loan, management must be 
satisfactory to it while any part of the loan remains unpaid. The pre- 
ferred stockholders as a class will be entitled to elect two of seven 
directors. While the RFC loan is outstanding, [second mortgage] bond- 
holders will have the right to elect a majority of the directors if there 
is a "default in the payment of any interest on new bonds." After the 
RFC loan is repaid, preferred stockholders will be entitled as a class 
to elect a majority of the board if there is a default in payment of inter- 
est, sinking fund requirements or principal on the bonds, or a default 
in six consecutive quarterly dividends on the preferred stock. 

B. ALLOCATION OF THE NEW SECURITIES 

For each $1,000 first mortgage bond and $200 of accumulated in- 
terest thereon to October 1, 1939, there will be issued $500 principal 
amount of new second mortgage bonds and $500 of new preferred 
stock in payment of principal and $100 of new preferred stock, repre- 
senting half of the interest accumulations. All of the new second mort- 
gage bonds and new preferred stock will be issued in exchange for the 
outstanding bonds. The bondholders are also to receive common stock 
at the rate of 20 shares for each $1,000 old bond, receiving as a class 
29,250 shares, or approximately 15% of the total common stock issue. 

The $60,000 plant mortgage [with accrued interest] is to be paid 
in cash in full. 

Merchandise creditors whose claims exceed $200 are to receive 
50% of the amount of their claim in cash and the balance in certificates 
of indebtedness. Creditors with claims of $200 or less are to be paid 
in cash in full. [The current liabilities of the trustee and the accrued 
taxes are to be assumed by the new corporation.] 



La France Industries 279 

Common stockholders retain their present securities, which will 
constitute 85 % of the total common stock to be outstanding upon con- 
summation of the plan. 

PART 3 
A. FAIRNESS OF THE PROPOSED PLAN 

The extent of the participation of any class of creditors or stock- 
holders in a plan or reorganization is to be determined by the estab- 
lished principle that claims and interests shall be provided for in the 
order of their seniority and only to the extent that the value of the 
debtor's properties supports recognition of each class. If the effect of a 
plan is to divert values to stockholders at the expense of creditors, or 
stated differently, if it imposes sacrifices upon creditors without pro- 
viding adequate compensation therefor, the plan fails to meet the statu- 
tory and judicial standard of "fairness." 

1. The Treatment Accorded Bondholders 

It is evident that the new bonds and preferred stock to be given 
the bondholders will not fully compensate them for their present claims, 
even if it be assumed that the full face amount of these new securities 
ultimately will be realized. Unless it can be shown that the proposed 
allocation of common stock to present bondholders makes up this de- 
ficiency at least, the plan must be condemned as unfair. Furthermore, 
the adequacy of the allocation of new securities to present senior credi- 
tors must be judged with due regard to the changes which the plan 
works upon their present status and contractual rights. 

The sacrifices which bondholders are called upon to make, even on 
the assumption that the new senior securities ultimately will be paid at 
par, may be summarized as follows: 

(1) The bondholders have a present claim for principal of 
$1,462,500 and accumulated interest of $292,500, an aggre- 
gate $1,755,000. The face value of the new bonds and pre- 
ferred stock totals $1,608,750, designed to cover the principal 
and one-half of the back interest on the bonds. The bondhold- 
ers' sacrifice of back interest will amount to $146,250. 

(2) The maturity of the bonds is being extended for 15 years fol- 
lowing consummation of the plan. 

( 3 ) The bondholders' lien position will be subordinated as a result 
of the RFC first mortgage. 



280 Case Problems in Finance 

At present the bondholders have a first mortgage on the 
plants of La France Industries and as to other assets (except 
Pendleton's) are on a parity with unsecured creditors. After 
consummation of the plan they will have a second mortgage 
on all plants; as to other assets, although they will be on a 
parity with unsecured creditors, they will be subordinate to the 
RFC lien. 

(4) As to half of the principal amount of their presently outstand- 
ing bonds, the bondholders are to receive only preferred stock, 
with a consequent change of status from creditor to stock- 
holder. 

( 5 ) In addition to the fact that the new securities to be given to the 
bondholders are inferior to their present bonds, the interest 
and dividend return on the new securities which bondholders 
are receiving for principal amount of old bonds will be less, by 
$153,375, over the life of the bonds than the return to which 
they were entitled on the old principal amount. 

(6) Dividends on the preferred stock will not be payable during 
the life of the RFC loan, so that as to actual dollar return, the 
bondholders during the life of the RFC loan can receive at best 
no more than 4% on the new second mortgage bonds, or $20 
per $1,000 of old bonds as compared with the $60 to which 
they are now entitled. 

All of these elements are important. Those which are not subject to 
precise measurement in terms of dollar value are nevertheless signifi- 
cant. It is therefore appropriate to analyze the available evidence re- 
lating to the value of the enterprise and of the new common stock, to 
determine whether the allocation of common stock to bondholders 
renders the plan fair. 

2. Book Value of Assets 

In a pro forma balance sheet annexed to the plan, the total value of 
the assets of the debtor and subsidiary debtor are $4,574,071.22 as of 
March 31, 1939- As against this there are current liabilities of the 
trustee of $247,781.36, which the reorganized company will have to 
meet. On the basis of these book values, the net assets of the reorgan- 
ized enterprise would total $4,326,289.86. This book figure includes 
fixed assets at $2,044,805.71, a valuation founded upon an appraisal 
submitted to the court in 1936. 



La France Industries 281 

This appraisal, however, was based upon reproduction cost new less 
depreciation. It is well recognized that this method of valuation is not 
a proper guide to the value of a going concern for reorganization pur- 
poses in the absence of a showing that the assets may be employed in 
the conduct of the enterprise so as to yield a fair return, after deprecia- 
tion, upon the values so assigned. The view generally accepted both by 
authorities in the field of finance and by the courts is that, for the pur- 
poses of reorganization, the reasonably prospective earnings of an enter- 
prise constitute the proper standard of measurement of its value as a 
going concern. 

3. Earnings of the Enterprise 

In order to translate earnings into a valuation, it is customary to 
use the device of capitalizing earnings which may be reasonably antici- 
pated. The rate of capitalization is determined in the light of the risks 
inherent in the venture and will reflect the rate of return which the 
investor might fairly require as compensation for an investment subject 
to such risks. 

In such a calculation, it is also proper, however, to consider sepa- 
rately those asset items which do not contribute to the earnings of the 
enterprise as a whole and which, consequently, have independent value 
in themselves. Accordingly, it has been generally agreed in this proceed- 
ing that the investment of La France Industries in the Canadian subsid- 
iary and the cash surrender value of the insurance on Mr. Davis' life 
should be valued separately. 

The life insurance is shown by the balance sheet of La France to 
have a cash surrender value of approximately $110,000. The value of 
the stock interest in the Canadian subsidiary depends upon the earnings 
of that company. 

a) The Canadian Subsidiary . — From 1933 to 1938, net profits 
of the Canadian subsidiary, after depreciation, averaged $73,381 annu- 
ally. There is apparently little reason for anticipating any substantial 
change in the earnings of this company from those of the recent past; 
and, consequently, past profits would appear to provide a reasonable 
guide to its future earnings. Because of the relative stability of operations 
and this company's earnings record, it is reasonable to capitalize those 
earnings at a rate of 9%, thereby valuing the Canadian enterprise for 
present purposes at approximately $815,000. 



282 Case Problems in Finance 

b) La France and Pendleton. — The past earnings record and future 
prospects of La France and Pendleton are of primary importance in 
determining the value of their remaining assets, both current and fixed. 

[In Table 1] historical earnings for the period 1933-1938 are 
shown as adjusted to eliminate charges which are not expected to recur 
in the future. 

{Table 1} 

NET PROFITS BEFORE INTEREST, DIVIDENDS FROM CANADIAN 

SUBSIDIARY, AND DEPRECIATION 

Adjusted for Non- 
Unadjusted recurring Items Depreciation 

1933 $456,629 $412,209 $209,884 

1934 ( 71,566)* 5,574 211,325 

1935 (172,927) ( 63,107) 207,251 

1936 120,509 216,974 191,856 

1937 42,290 142,261 180,607 

1938 123,819 163,956 181,592 

1933-1938 av 83,125 146,311 197,086 

1936-1938 av 95,539 174,397 184,685 

* ( ) = Loss. 

It appears that, against actual average annual earnings before de- 
preciation of $83,125 for the period 1933-1938, the indicated adjusted 
earnings are $146,311, or an increase of 76%. Similarly, for the period 
1936-1938, the actual average annual earnings before depreciation are 
$95,539, whereas the adjusted earnings are $174,397, or an increase 
of 83%. 

The results of the three years from 1936 to 1938 appear to provide 
the best basis upon which to judge future possibilities. Operations prior 
to 1936 were affected by many extraordinary factors. The period 1936- 
1938, on the other hand, although the period of the trusteeship, was not 
a period of unusual business activity or of depression for this company. 
The earning prospects for La France Industries and Pendleton are in- 
fluenced by factors which in part make it reasonable to anticipate some 
improvement over recent profit figures, as adjusted by the elimination 
of nonrecurring charges. The weight of these factors is reviewed in the 
following: 

( 1 ) There is reason to believe that because the company has been 
in reorganization and has had limited working capital and 
credit, volume and profits have been curtailed to some extent. 
However, it is also clear that the trusteeship has been more 



La France Industries 283 

than ordinarily efficient in instituting substantial economies, 
maintaining the "esprit de corps," and helping to "hold a 
certain trade position." Consequently, while the termination 
of the proceedings and the improvement of the working capi- 
tal position as a result of the RFC loan may aid earnings, only 
moderate improvement may be assumed merely by reason of 
these factors. 

( 2 ) There are undoubtedly some new types of products which the 
company could make on its present looms and for which a 
demand exists. However, there is no indication that these new 
lines would be likely to result in any substantial improvement 
in volume or profits. 

Considerable testimony was adduced particularly on the 
^ subject of possible expansion into the automobile fabrics field. 
While it was alleged that contacts with large automobile man- 
ufacturers are necessary in order to enter this highly specialized 
phase of the textile business, it was also stated that the reorgan- 
ized company would possess such contacts. However, neither 
the testimony nor the company's history gives reasonable assur- 
ance of the debtor's ability or intention to enter this field. More 
significantly, no estimate has been ventured as to what such 
business might mean in terms of additional volume or profits. 
Furthermore, there is uncertainty as to whether entry into this 
field would not be accompanied by curtailment of production 
or increased operating costs on present lines, or else by an 
expansion of inventories of such lines with a greater risk of 
inventory loss and an attendant need for additional financing. 
Consequently, no allowance for a major increase in profits 
from this possible type of expansion appears appropriate at 
this time. 

(3) The company's principal activity, constituting about 80% of 
its business, is the manufacture of upholstery fabrics for sale to 
the furniture trade. The prospects for the sale of these products 
depend in large measure upon the volume of furniture manu- 
facturing. This, in turn, is affected by residential construction. 
On the basis of the current estimates concerning this type of 
building activity, it appears reasonable to conclude that some 
improvement in this aspect of the business may be anticipated. 



284 Case Problems in Finance 

(4) The manufacture of rugs and allied products, which in 1938 
accounted for 19% of total sales, is to some extent influenced 
by foreign competition, although perhaps less so recently as a 
result of a change in the nature of this line. If no change in the 
tariff situation is assumed, it appears reasonable to expect this 
phase of the business to contribute to total future operations in 
much the same fashion as before. There is nothing in the na- 
ture of, or future outlook for, this portion of the debtor's busi- 
ness which foreshadows any appreciable growth. 

A consideration of the various elements which are likely to influence 
future earnings leads to the conclusion that it is reasonable to anticipate 
that annual profits of the reorganized company will exceed those which 
were reported by La France and Pendleton for the years 1936 to 1938. 
It is also reasonable to expect that annual earnings in the future may be 
in excess of the $175,000 figure representing the 1936-1938 average, 
after adjustment for nonrecurring items but before depreciation. There 
would not appear, however, to be any basis for expecting any radical in- 
crease over this figure. 

4. Conclusions as to Fairness 

The initial aspect of fairness to which the foregoing data are ad- 
dressed is whether, assuming that the new bonds and preferred stock 
adequately compensate for bondholders' present claims for principal and 
one-half of accumulated interest, 1 5 % of the common stock equity is 
fair compensation for the sacrifices which they are called upon to make. 
As we have observed above, there are, in addition to the definite loss of 
$146,250 of back interest and of approximately $150,000 representing 
reduced income on the new securities to be given to bondholders, other 
significant sacrifices not subject to precise monetary measurement. 

If, for the moment, there is considered only the $146,250 loss of 
accumulated interest (and it is assumed that the purpose in allotting 
bondholders 1 5 % of the common stock equity is to compensate them 
for this loss of accumulated interest) , 15 % of the common stock equity 
would have to have a value of $146,250, if this minimum standard of 
fairness is to be met. On that basis, the total value for all of the com- 
mon stock of the new company would have to equal $975,000. That 
this standard is not met readily appears from the following analysis. 

The new company will have claims senior to the common stock as 
follows: 



La France Industries 285 

RFC loan $ 600,000 

Second mortgage bonds 73 1,250 

Certificates of indebtedness 173,735 

6% preferred stock 877,500 

$2,382,485 

If senior issues are to be adequately covered and sufficient value re- 
main for the common stock so that the plan would fairly compensate the 
bondholders for their loss of $146,250 of accumulated interest by the 
allotment of 15% of the common stock, the value of the enterprise 
must consequently equal approximately $3,360,000 ($975,000 plus 
$2,382,485). If the independent value of $815,000 for the company's 
investment in the Canadian subsidiary and the $110,000 cash value of 
the life insurance are deducted, then there must be a going concern value 
of $2,435,000 for La France Industries and Pendleton alone. 

Such a going concern value is tenable only to the extent that it is 
consistent with and represents a fair capitalization of reasonably pro- 
spective earnings of La France and Pendleton after depreciation. Be- 
cause of the apparent risks involved in the operations of the American 
companies evidenced in part by their history of fluctuating income, 10% 
would seem to be a fair rate of capitalization. On the basis of this rate 
of capitalization, it would be necessary, in order to show a going concern 
value of $2,435,000, that reasonable prospective earnings, after de- 
preciation, be approximately $243,000 annually for La France and Pen- 
dleton. The past earnings record of the American companies and the 
factors affecting future prospects do not support such an estimate. 

As we have indicated, adjusted earnings before depreciation aver- 
aged approximately $175,000 from 1936 to 1938, and there is no 
reason to anticipate more than a moderate increase above this level. 
A proper depreciation charge would appear to exceed $65,000 annu- 
ally, reducing the $175,000 figure to no more than $110,000 after 
depreciation. 

Clearly it would require undue optimism to predict future annual 
earnings of $243,000 after depreciation. In order to reach this result, 
the maximum net earnings for the period 1936-1938 of $110,000 
would have to be increased by approximately 120%. 

It does not appear, therefore, that prospective earnings would sup- 
port a going concern value for the American companies equal to 
$2,435,000. Consequently, [earnings] do not provide a basis for estab- 
lishing a value of the total enterprise sufficiently high so that the 1 5 % 
of the common stock to be given to the bondholders can be regarded as 



286 Case Problems in Finance 

adequate compensation for their loss of accumulated interest alone. On 
this basis alone, therefore, the plan must be considered unfair. Further- 
more, this approach has given no consideration to the other significant 
sacrifices which bondholders will make under the proposed plan of re- 
organization. 

Conversely, the earnings record and prospect for La France Indus- 
tries and Pendleton raise a serious question as to the extent of any par- 
ticipation in the new company to be allotted to the present common 
stockholders. To demonstrate on an earnings basis value allocable to the 
present common stock sufficient to support its proposed participation 
in this plan, it would be necessary to show a substantial increase in gross 
earnings and a substantial reduction in depreciation from the level 
which the company has recently been charging. Therefore, in view of 
our previous discussion, it appears that the extent of participation by the 
old common stock which the present plan proposes is not supportable. 

B. FEASIBILITY OF THE PROPOSED PLAN 

The only fixed charges set up by the plan are those on the RFC loan 
and the second mortgage bonds. On the basis of past earnings and assum- 
ing continuation of past dividend income from the Canadian subsidiary, 
it appears that the company would be prepared to meet, with an ade- 
quate margin, the required interest and amortization on the RFC loan 
and the interest on the second mortgage bonds. 

It should be noted, however, that the plan contains elements of un- 
soundness. Too large a proportion of senior securities is imposed upon 
the reorganized company. The new first mortgage, second mortgage 
bonds, certificates of indebtedness, and preferred stock represent total 
face value of $2,382,485. This constitutes about 55% even of the book 
value of the assets of the company ( less current liabilities ) . The extent 
to which these senior issues will constitute the greater part of the com- 
pany's total value is even larger if such value is based on earnings. 

While this feature of the reorganized company's capital structure 
may not of itself brand the plan as unsound, it should be considered in 
connection with the further fact that under the plan additional claims 
prior to the common stock will accumulate in the form of unpaid divi- 
dends on the preferred stock. The plan provides that no dividends shall 
be payable on the preferred stock during the life of the RFC loan. At 
the same time, dividends will accumulate on this stock at the rate of 6% 
per annum. Even on the basis of a maximum estimate of anticipated 



La France Industries 287 

earnings ($300,000 per annum before depredation for the entire enter- 
prise, including dividends from the Canadian subsidiary ) , it appears un- 
likely that the RFC loan will be paid off in less than five years. Even if 
the loan were paid off in five years, there would necessarily be an accu- 
mulation of $30 per share at the end of that period on each of the 8,775 
shares of preferred stock outstanding, or a total accumulation of 
$263,250. 

The fact that the dividends on the preferred stock will not be paid 
during a period of years following reorganization, and that over this 
period large arrearages will accumulate, clearly indicates, we believe, 
that the contemplated plan is unsound. Moreover, eventual payment in 
cash of the accumulated dividends would appear open to question. Ex- 
perience shows that in such situations removal of the burden of the ar- 
rearages through some form of recapitalization plan has often been 
necessary. 

Under these circumstances we do not believe that the plan meets 
the statutory requirement of feasibility. 



PART 3 

RESERVE AND DIVIDEND 
POLICIES 



VVVVVVVV\\VVV\AAVV\\VVVVVVWWV\V\\\VV\\VVV\VV\\VWWAVVVWVV^^ 



Mayfair-Cottle Company 



MVVVVV\VVVVVVVV\VWVVMVVVVVV\\>AVVVVVVVVVVV\VVVVVV\AVV\>\^^ 



While home on terminal leave in November, 1945, Jerome Prescott 
was offered the positions of treasurer, controller, secretary, and member 
of the board of directors of the Mayfair-Cottle Company, one of the 
three leading department stores in his home city. He was then 42 years 
old. Prior to the war he had been a partner in a medium-sized invest- 
ment counsel firm in the same city. He accepted the offer and took up 
his new duties early in December. 

The store operated by the Mayfair-Cottle Company was patronized 
almost exclusively by women. It was an old, well-known store with 
which people liked to trade. Contrasted with other department stores, it 
did not carry furniture or men's furnishings, shoes, or clothing. It did 
not have a bargain basement, candy department, soda fountain, or lunch- 
room. 

After assuming his new duties, Mr. Prescott visited a number of the 
company's executives for the purpose of obtaining better understanding 
of the store's operations and its financial problems. After talking with 
Mr. MacGregor, the chief cashier, Mr. Prescott decided that the com- 
pany's policies with reference to reserves should be reviewed promptly, 
for Mr. Prescott learned that Mr. Weiss, the late treasurer, had not fol- 
lowed completely the instructions of the board of directors with refer- 
ence to "funding" certain reserves.^ 

In December, 1943, the directors had voted to instruct the treasurer 
to maintain an investment in United States tax anticipation notes^ in an 

■"- When cash or other liquid assets are set aside for the sole purpose of meeting a need 
for which there is a reserve, the reserve is said to be "funded." 

^United States tax anticipation notes (Treasury tax savings notes) could be bought 
at any time at par and could be used at par in payment of federal income taxes. They bore 
interest at 0.05% per month for the first six months, the rate increasing so that in the 
period from 2^ to 3 years the rate was 0.11% per month. 

291 



292 Case Problems in Finance 

amount equal to the estimated liability for income and excess profits 
taxes. Mr. Weiss had commenced buying these notes in the preceding 
summer, and it appeared that he had recommended the policy which the 
directors had adopted. 

At the same time, but after considerable debate, the directors had 
voted to direct the treasurer to invest the full amount of the reserve for 
postwar requirements in United States Treasury certificates of indebted- 
ness.^ At the time this reserve amounted to $300,000. It was later raised 
to $500,000 by vote of the directors. This reserve for postwar require- 
ments was established from surplus to provide for an air conditioning 
installation, new fixtures for the store, and also increases in working 
capital necessary because of larger inventories and receivables expected 
as a result of relaxation of wartime rules and the growth in sales due to 
higher prices. 

Although the directors had set up a reserve of $200,000 for postwar 
price declines in June, 1945, they did not vote to fund it. 

In talking with Mr. Casteel, the vice-president in charge of merchan- 
dising, Mr. Prescott learned that the Mayfair-Cottle Company normally 
borrowed from banks to finance its seasonal needs during the fall and 
Christmas seasons. Since the company had a long record of profitable 
operation, the company had never had difficulty in arranging loans. It 
was Mr. Casteel's understanding that the company could borrow from its 
bank, currently on 90-day, 1 ^ % notes, amounts sufficient to meet these 
current needs. Because of difficulty in obtaining merchandise for the cur- 
rent Christmas season Mr. Weiss had not thought it necessary to borrow 
in the autumn of 1945. Instead, Mr. Casteel said, he had provided funds 
by abstaining from purchasing the full amount of United States tax an- 
ticipation notes required by the resolution of the board of directors with 
respect to funding the reserves. 

Mr. Casteel stated that he was not in sympathy with the directors' 
ideas on the funding of reserves. He expressed the opinion that as soon 
as inventories and receivables reached normal postwar levels it would 
be found that the company could not afford to maintain funded reserves 
during seasonal peaks. Mr. Casteel suggested that Mr. Prescott make a 
study of the store's seasonal pattern at the earliest opportunity and re- 



^ United States Treasury certificates of indebtedness were obligations of the U.S. Treas- 
ury issued for the term of one year and which, in 1945, carried a 0.875% stated annual 



Mayfair-Cottle Company 293 

consider the policy on funding reserves in the hght of what he dis- 
covered. 

As he continued his investigation of this matter, Mr. Prescott learned 
from Mr. MacGregor that the company had four principal depository 
banks and also maintained balances of about $5,000 in each of two sub- 
urban banks. Mr. MacGregor stated that Mr. Weiss had considered 
$250,000 as the minimum amount of cash and bank balances required 
for the company's current volume of business. Mr. Prescott had already 
observed from a study of the record of daily bank balances that the end- 
of-month cash balance usually ran from $125,000 to $200,000 higher 
than the month's minimum balance, which usually occurred around the 
tenth of the month, as many suppliers sold to the store on 10 EOM 
terms. 

From Mr. Walcott, the credit manager, Mr. Prescott learned that 
the volume of accounts receivable from customers was currently below 
normal because of Regulation W of the Board of Governors of the Fed- 
eral Reserve System which had been adopted during the war as an anti- 
inflationary device. This regulation provided that all charge sales had to 
be paid for on the tenth day of the second calendar month following the 
month during which the charge sale was made. The store was prohibited 
from granting further credit to customers who had failed to pay their 
accounts within the specified period. 

After obtaining this information, Mr. Prescott requested his secre- 
tary to bring him monthly financial statements covering the periods of 
maximum seasonal need in the last two fiscal years. These are presented 
in Exhibit 1. Mr. Prescott was determined to learn something about the 
seasonal pattern of the company's finances and to work out a policy with 
regard to funding reserves that he could recommend to the directors. 
Knowledge that his predecessor had not been fully complying with the 
directors' instructions made this question urgent in Mr. Prescott's mind. 

In reviewing the figures which his secretary presented to him, Mr. 
Prescott became confused by the changes in the amounts of reserve for 
taxes in the two classifications which took place at the end of the fiscal 
year, July 31, 1945. Mr. Delaney, the chief accountant, told him that at 
the end of each fiscal year the income and excess profits taxes accrued 
during the preceding 12 months were transferred out of the "Reserve 
for Taxes Payable in Next Fiscal Year" to the "Reserve for Taxes Pay- 
able in Current Fiscal Year." The sums remained in this account until 



294 Case Problems in Finance 

paid or adjusted. The "Reserve for Taxes Payable in Next Fiscal Year" 
was accumulated by monthly entries which would bring the estimated 
liability up to the most recent estimate of taxes based on income for the 
fiscal year to date. Mr. Delaney also reminded Mr. Prescott that, since 
the fiscal year ended July 31, the quarterly tax payment dates were 
October 15, January 15, April 15, and July 15.* 

* Federal income taxes on corporations are payable in four equal quarterly install- 
ments. The first installment is due 2^ months after the end of the company's fiscal year. 
Thus, companies whose fiscal year ends December 31, must pay their taxes on or before 
March 15, June 15, September 15, and December 15. 



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Hilton Company 



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Late in April, 1938, the directors of the Hilton Company met to con- 
sider the question of dividend payments. The last dividend had been 
voted at a meeting on December 28, 1937, payable February 1, 1938, 
and announced as follows: 

Cumulative convertible preferred stock: a regular quarterly dividend of 25 
cents per share. 

Common stock: a dividend of 25 cents per share. 

The Hilton Company, located and incorporated in Ohio, was an es- 
tablished manufacturer of automatic machine tools, which were used in 
several industries. A competent engineering staff was continuously em- 
ployed to carry out improvements in design; these were incorporated in 
the product as soon as they were proved to be desirable. 

It had been the experience of the company over a period of years 
that the demand for its product was subject to extreme fluctuations. 
Manufacturers bought new machinery in substantial volume only at 
times when the actual or prospective profits of their businesses were 
satisfactory. Consequently, the demand for the product of the Hilton 
Company was extremely difficult to predict for periods longer than four 
to six months. A fairly steady volume of repair orders could be expected, 
but the net earnings of the company varied rapidly from profit to loss, 
as indicated in Exhibit 1. The demand for replacement parts created a 
considerable problem of inventory control since over 250,000 items had 
to be carried in stock. 

The capitalization of the Hilton Company which existed in 1938 
was the result of a voluntary reorganization that had taken place Decem- 
ber, 1937, with the approval of more than 90% of each class of security 
holders concerned. The reorganization had been put through to accom- 
plish the following announced purposes:^ 

^ As stated in various letters to stockholders. 

296 



Hilton Company 297 

1. Simplifying [the corporation's} capital structure; 

2. Reducing its outstanding indebtedness; and 

3. Enabling the payment of dividends on the new stock proposed to be is- 
sued. 

With respect to the last of these purposes, the management of the 
company pointed out that it was necessary to remove the balance sheet 
deficit in order to make dividend payments legal. No dividends had 
been paid on the old stock for a number of years. Under the laws of 
Ohio, dividends could be paid only if the company had a balance sheet 
surplus. The management stated in a letter to the stockholders that the 
plan would "make available future earnings for distribution as divi^ 
dends." 

The principal effects of the reorganization upon the company's fi^ 
nancial structure are reflected in Exhibit 2. The new shares were ex- 
changed for the old on the following ratios: 

Securities of New Company 

3 shares of new cumulative convertible preferred stock and 3 shares of new 
common stock for 1 share of preferred stock and $73.50 accumulated dividends. 

1^ shares of new cumulative convertible preferred stock and 1^ shares of 
new common stock for 1 share of second preferred stock and $87.50 accumu- 
lated dividends. 

^ share of new common stock for 1 share of common stock. 

The long-term debt was reduced by the use of treasury cash and 
funds obtained from the sale of units consisting of one share of convert- 
ible preferred stock and one share of common stock of the new company. 
The units were offered to holders of the new convertible preferred stock; 
the only actual sales were to a group of officers and directors of the com- 
pany who had agreed in advance to exercise the rights that they would 
receive as a result of the new financing. About $675,000 was obtained 
from these persons. 

The balance of the old long-term debt was replaced by the new 
serial loan of $900,000, which was placed with a commercial bank in 
Chicago. The company agreed to retire this loan in annual installments 
of 20% of the company's net earnings in a fiscal year, or $110,000, 
whichever sum was the greater. It had the privilege of making these 
payments at any time during the year. Interest was to be charged on 
outstanding balances at the rate of 4% per annum for the first year, 
4^% for the second year, then 5% to maturity. The company agreed 
that the entire loan should become due at any time when the total cur- 



Exhibit 1 

HILTON COMPANY 

Income Data 

(Dollar figures in thousands) 

Income Net Income 

Sales Depreciation Taxes after Taxes 

1930 $3,072 $217 ... $585'' 

1931 2,775 218 ... 315** 

1932 1,487 191 ... 519'* 

1933 2,788 179 $ 10 171 

1934 4,868 186 75 389 

1935 2,975 188 ... 9 

1936 5,234 190 215* 535 

1937 7,160 205 350* 476 

Jan. 1-Mar. 31 1938 1,731 62 20 115 

Mar. 1-31 1938 482 18 4 29 

* Includes provision for federal surtax on undistributed profits of $92,000 in 1936 and $131,000 in 

1937. This surtax was established by the Revenue Act of 1936. Since repeal of this surtax appeared 
imminent early in 1938, allowance for income tax in the period January-March, 1938, represented 
allowance only for the normal tax of 15% of net income for the quarter. 

d Deficit. 



Exhibit 2 

HILTON COMPANY 

Balance Sheet as of March 31, 1938 

(Dollar figures in thousands) 

ASSETS 

Cash $ 720 

Receivables, net 1,664 

Inventories (estimated* ) 1,013 

Current assets $3,397 

Notes receivable after one year 70 

Special insurance deposits 35 

Inactive inventory, net 48 

Unmarketable securities, net 80 

Treasury stock 1 

Deferred charges 8 

Plant accounts, net 2,795 

Total assets 

LIABILITIES, CAPITAL, AND SURPLUS 

Accounts payable $ 87 

Accrued liabilities 284 

Current installments of serial loan 110 

Current liabilities $ 481 

Serial notes 790 

Reserve for federal income tax 131 

Preferred stock (78,350 shares at $20) ' 1,567 

Common stock ( 106,400 shares at $5) 532 

Surplus, December 17, 1937 2,864 

Earned surplus 69 

Total liabilities, capital, and surplus 



$6,434 



$6,434 



* In preparing Interim statements, the treasurer estimated inventory values according to a formula 
which had proved to be reliable. Physical inventories were taken only at the end of the fiscal year. 



Hilton Company 299 

rent assets of the company, after the deduction of all indebtedness ex- 
cept for the outstanding serial loan, should be less than one and one-half 
times the loan balance. 

The stock of the company was widely held in Ohio and neighboring 
states. It was unlisted and had a small turnover. No stockholder held a 
controlling interest in the company, the largest individual holding rep- 
resenting about 15% of the voting stock. Five other individuals each 
held about 2^% of the stock. 

At their meeting in April, 1938, the directors were given the infor- 
mation presented in Exhibits 2 and 3. The president pointed out that it 
was clear that many of the company's customers would experience oper- 
ating and other losses at least for the first half-year. Inventories were 
large, and prices were at very low levels. 

The president stated that, because of the considerable backlog of 
orders carried forward by the company from the previous summer, oper- 
ations through the winter months had shown some profit, especially in 
December and January. He pointed out, however, that the contraction 

Exhibit 3 

HILTON COMPANY 

Income Statements 

January 1, 1938, to March 31, 1938, 

AND Month of March, 1938 

(Dollar figures in thousands) 

]an. 1,1958— 

Mar. 5 h 1958 Mar. 1958 

Total sales $1,731 $482 

Cost of goods sold and expenses of operation $1,518 $428 

Depreciation of active plant 45 13 

Total operating expenses $1,563 

Net operating income after depreciation $ 168 

Dividends, interest, royalties 7 

Total income $ 175 

Interest on long-term debt $ 13 

State taxes and federal income tax 4 

Provision for federal income tax* 20 

$ 37 

Net expenses on inactive plants $ 3 

Depreciation of inactive plants 17 

Losses on inactive plants $ 20 $ 6 

Nonrecurring losses 3 

Net income 115 29 

Dividends paid (February, 1938) 47 

* 15% normal tax only. 



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300 Case Problems in Finance 

in new business bookings which had set in early in the fall was continu- 
ing and that such bookings were now running at the lowest rate in sev- 
eral years. Reference was also made to the curtailed rate of operations 
in effect at the company's plants and to the uncertain future for business 
generally. The assistant treasurer of the company estimated that losses 
for April would amount to more than $40,000 but that operations in 
May would probably result in a small profit. 



iVVVVV\VVVVVVVVVVVVVVVVVVVVW^VVVVVViVVVVV\VVVVVVVVVVVVVVV^^ 



Nostrand Pressure Casting Company 



VVWA^\>^VV\V\\VV\V\VVVVVVVVV\VVVVVVVVVVV\VV\VVVVVVVWV\VVV^^ 



During November, 1941, the directors of the Nostrand Pressure 
Casting Company met to consider what dividend, if any, should be paid 
on the common stock in December. The company had paid dividends 
quarterly through 1940 and 1941, in amounts as shown in Exhibit 1, 
and the directors had adopted a policy of paying dividends as regularly 
as possible. Despite a change in the nature of production from civilian 
to military products, volume and profit margins had been maintained 
through 1941, as shown in Exhibit 2. Exhibit 3 contains selected bal- 
ance sheet items for various dates. In November, 1941, it was estimated 
that the figures for the entire year would show improvement over those 
of 1940. Nevertheless, certain directors questioned the advisability of a 
further cash distribution to stockholders because of recent capital ex- 
penditures for defense plant, probable increased income taxes in 1942, 
and a desire to improve the working capital position so that the company 
would be better able to care for any contingencies that might arise. One 
director also pointed out that annual dividends totaling $2.50, the 1940 
rate, gave a yield or return of almost 6% on the current market price of 
the common stock. 

In 1941 the Nostrand Pressure Casting Company was an important 
manufacturer of nonferrous die castings, made by forcing molten metal 
into metal molds or dies. Somewhat less than half of the parts made in a 
normal year were for automobiles and accessories, and the remainder 
were made for many kinds of products. Thus, although it was the com- 
pany's policy to manufacture on order only, the diverse nature of the 
demand caused the seasonal variation to be small. In peacetime the 
company's demand for metals was about 50% for zinc, 40% for alu- 
minum, and the balance for copper, magnesium, and lead. During 1940 
and 1941, because of defense priorities, the company used the maximum 

301 



302 Case Problems in Finance 

amounts of aluminum allowed by the U.S. Office of Production Manage- 
ment (O.P.M.) and the total amount of zinc allocated on its orders. 
Due to the decrease in zinc available, some auto parts and some other 
parts formerly produced in zinc alloy were converted to lead. 

As the defense program advanced, the nature of the company's or- 
ders changed. By November, 1941, 50% of the company's output was 
on defense parts, and it was anticipated that 90% of the output for 1942 
would be for military purposes. Most of the company's defense orders 
were on subcontracts; and, on the whole, orders came from the same 
customers who had been buying from the company in peacetime. In 
negotiating these new contracts, the company continued its policy of 
limiting contracts to cover not more than 90 days' production, so that 
prices could be adjusted easily to changing costs. Since the company con- 
tinued to sell to the same customers, its rate of collection of receivables 
continued to be less than 30 days. 

With respect to inventories, the company's peacetime policy was to 
carry amounts of metals which were seldom in excess of the quantity 
needed for four weeks' production. A great deal of magnesium was 
needed in certain of the castings made for war purposes, and the com- 
pany adopted a policy of carrying two or three weeks' supply of this 
metal. In November, 1941, the O.P.M. ruled that companies should not 
carry more than a four weeks' supply of aluminum, a six to eight weeks' 
supply of copper, a two to three weeks' supply of magnesium, an eight 
weeks' supply of lead, and zinc only as needed for immediate use. 

Early in 1940 the company embarked upon a program of modern- 
izing and expanding its plant facilities. Much of the expansion was com- 
pleted in 1940, and by November, 1941, all but $200,000 of an origi- 
nal capital budget of $1,500,000 had been expended. The balance was 
to be expended by the end of 1941. All the funds for the expansion and 
modernization had been provided from internal sources. It was expected 
that no further substantial investment in plant or equipment, other than 
reinvestment of depreciation, would be required, since the company's 
capacity seemed ample for the foreseeable demand. 

The management of the Nostrand Pressure Casting Company had 
found that the question of providing funds for taxes was of ever-increas- 
ing importance. Property, franchise, and similar taxes were not varying 
greatly from year to year, but taxes based upon income — chiefly the 
federal income, excess profits, and defense taxes — were becoming larger. 
Such taxes were levied upon the income of a certain year and were pay- 



NosTRAND Pressure Casting Company 303 

Exhibit 1 

NOSTRAND PRESSURE CASTING COMPANY 

Dividends Paid per Share of Common Stock 

1940 AND First Three Quarters of 1941 

1940 

April 1 $0.50 

July 1 0.50 

Oct. 1 0.50 

Dec. 31 1.00 

$2.50 
1941 

April 1 $0.50 

July 1 0.50 

Oct. 1 1.00 

able during the following year, so that the company adopted the poliq^ 
of reserving funds quarterly, based upon the current earnings and ex- 
pected tax rates. A current liability was set up for the taxes to be paid in 
the ensuing four quarters, and current assets were earmarked accord- 
ingly. Taxes payable in later quarters were also estimated but not carried 
as current items. At the end of each quarter, the company's probable tax 
liabilities were recomputed in the light of estimates of earnings and of 
probable tax rates. 

Exhibit 2 

NOSTRAND PRESSURE CASTING COMPANY 

Profit and Loss Figures, Various Periods, 1940-1941 

(Dollar figures in thousands) 

October October 10 Months 10 Months 12 Months 

1940 1941 1940 1941 1940 

Net sales $1,380 $1,360 $8,660 $14,387 $11,231 

Gross profit 259 353 1,731 3,401 2,801 

Operating profit, before depre- 
ciation 186 275 1,175 2,520 1,764 

Net profit before federal income 

taxes 172 245 1,046 2,172 1,394 

Estimated federal income taxes . 89 170 431 1,344 619 

Profit after taxes 83 75 615 828 775 

Earnings in 1941 were taxable at rates established by the Revenue 
Act of 1941. In November, 1941, management anticipated that a new 
revenue act providing for a significant increase in taxes would be passed 
and would apply to income earned in 1942. 

After August 1, 1941, the company commenced to purchase U.S. 
Treasury Series B tax notes for the purpose of accumulating funds to pay 
taxes in 1942. These notes were dated August 1, 1941, to mature Au- 



304 



Case Problems in Finance 



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306 Case Problems in Finance 

Exhibit 4 

NOSTRAND PRESSURE CASTING COMPANY 

Monthly High and Low Quotations 

NOSTRAND Dow- Jones Averages of 

Common Stock Industrial Common Stocks 

1941 High Low High Low 

January 46i 42 133.94 123.86 

February 46i 41 125.13 117.57 

March 45 40| 124.20 119.98 

April 41 34| 125.28 115.33 

May 40 34i 118.45 114.78 

June 39 34i 125.14 115.52 

July 38h 341 130.37 122.54 

August 36f 34i 128.69 124.66 

September 44 36^ 130.00 125.33 

October 43| 39i 127.20 117.40 

gust 1, 1943. The purchase price was at par and accrued interest, the 
rate of interest being 4 cents per month per $100. These notes could be 
used at par and accrued interest during and after the third month from 
purchase for the payment of liabilities on various federal taxes based 
upon income. The interest earned by these notes was not exempted from 
the federal income tax. The notes could be redeemed without interest on 
30 days' notice, after the first 60 days. 

The stock of the Nostrand Pressure Casting Company was widely 
held. No single interest owned more than 10% of the stock. The shares 
were listed on an important stock exchange, and the record of the 1941 
market prices through October appears in Exhibit 4. The board of direc- 
tors of the company numbered ten, four of whom were officers of the 
Nostrand Pressure Casting Company, two were partners of investment 
banking firms, one was the vice-president of the principal commercial 
bank used by the company, and the others were executives of industrial 
concerns. 



^\\VVVVVVVVVWVVV\VVVVVVVVV\\VVVVVWVVV\VVVV\AA/V^^ 



Curtiss- Wright Corporation' 



U\\\VVVVVVVVVA^VVVVVVV\\VVVWVVVVVVVVVUVVVVVVW^\VVA\VVV\VVV^^ 

In April, 1948, holders of the Class A and the common stock of the 
Curtiss- Wright Corporation received a letter from a committee of three 
shareholders who claimed to own 16,500 shares of the common stock. 
In their letter, this committee asked support at the forthcoming annual 
meeting of the shareholders for eight nominees to the eleven-man board 
of directors of the corporation. According to the committee, the manage- 
ment should be criticized for accumulating excess liquid funds and for 
discrimination against the common stock in favor of the Class A stock 
with reference both to dividends paid over several years and to the pur- 
chase and retirement of the Class A stock in 1947. 

If elected, the eight nominees would support the immediate payment 
of a cash dividend of $7.00 per share on the common stock (requiring 
$52,024,273) or, as an alternative, the retirement, by solicitation of 
tenders, of as many as 3,716,020 shares (50% of the outstanding 
amount) of common stock at $14 per share (requiring $52,024,280). 

Responding to this appeal, the management of the Curtiss- Wright 
Corporation, in a letter to stockholders signed by G. W. Vaughan, the 
president, stated that a partial liquidation "at this time" would jeopard- 
ize the future of the company. Reviewing past dividends, the letter 
pointed out that over the past 14 years, dividends to common sharehold- 
ers had amounted to $39,000,000 compared with $23,000,000 paid to 
Class A shareholders. Referring to the purchase and retirement of Class 
A shares in 1947, the letter stated: 'The charter of the Corporation re- 
quires the payment of $2.00 per share on the Class A stock in any one 
year before any dividends may be paid on the common stock. Therefore, 
the purchase by your company of Class A stock at a reasonable price im- 
proved the capital structure of your company." 

In conclusion, the letter urged the shareholders to sign an enclosed 
proxy, supporting management nominees for the eleven directorships. 

^ The material in this case is from various published sources. 

307 



308 Case Problems in Finance 

The Curtiss- Wright Corporation began business in August, 1929, 
as a holding company. For many years previous to this the various sub- 
sidiaries of the company had been engaged in the manufacture of air- 
craft and engines for aircraft. These companies were acquired by means 
of exchange of shares of the two classes of Curtiss- Wright stock for the 
stock of the subsidiaries. Through such exchanges the Curtiss- Wright 
Corporation acquired well over 90% ownership in all the subsidiary 
companies. In 1936 all of the principal subsidiaries were dissolved, ex- 
cept Wright Aeronautical Corporation, and the operations were taken 
over by the parent company. 

On May 29, 1936, Curtiss- Wright Corporation offered directly to 
both classes of stockholders about 800,000 common shares at $4.00 per 
share. These shares were offered on the basis of one share for every 10 
shares of Class A or common held. Warrants for 644,453 shares were 
exercised under this arrangement. 

The provisions of the two classes of stock are summarized in Ex- 
hibit 1. The record of market prices in recent years appears in Exhibit 2. 

From 1929 to 1936 the Curtiss- Wright Corporation experienced 
difficult times. A loss of over $9,374,000 was suffered in 1930 alone. 
In 1936 the business outlook became definitely better as sales increased 
over 70% in one year. This upward trend in sales and profits continued 
until 1945, when sales reached $1.1 billion and profits, after taxes, 
$24.4 million. The record of sales and profits appears in Exhibit 3. 

The prosperous period of 1936-1945 permitted the building-up of 
the company's working capital. In this period the company had net prof- 
its of $118 million. From these profits were deducted dividends of $51 
million, leaving $67 million plus depreciation charges of $52 million, 
or $119 million in funds provided by operations. By December, 1945, 
net working capital reached $138 million; and in December, 1946, the 
sum was still $110 million after capital expenditures of $17 million in 
that year. At a special stockholders meeting in 1947, Mr. Vaughan spoke 
of an "excess" of some $60 million in net working capital. Balance 
sheets of the company in recent years appear in Exhibit .4. 

In 1944 a policy of nonaviation diversification was commenced with 
the purchase of the L. G. S. Spring Clutch Corporation. This was fol- 
lowed in 1945 by the acquisition of Marquette Metal Products Co., a 
manufacturer of metal textile spindles. The Victor Animatograph Corp., 
one of the largest producers of 1 6 mm. film projectors, cameras, and ac- 
cessories, was purchased in mid- 1946. All three companies were pur- 



Par Value 



CuRTiss- Wright Corporation 

Exhibit 1 

curtiss-wright corporation 
Summary of Provisions of Capital Stock Issues 
Class A: $1.00. 
Common: $1.00. 



309 



Redemption 



Conversion 



Dividends 



Class A: In whole or in part at any time at $40 per 
share and declared dividends, if any. 

Class A: Into common, share for share, at any time at 
the option of the holder. 

Class A : Noncumulative, but entitled to not more than 
$2.00 per share in any year, if declared, before any divi- 
dend can be paid on the common stock. 
Record of dividends since the formation of the com- 
pany. "Your company is not and never has been on a 
regular basis as far as dividends are concerned, but they 
are declared at the discretion of the directors of your 
corporation." 

Annual Payment 





Years Class A 


Common 




1929-1935 None 


None 




1936-1937 $0.50 


None 




1938 1.00 


None 




1939 2.00 


None 




1940 2.00 


$0.50 




1941-1942 2.00 


1.00 




1943-1944 2.00 


0.75 




1945-1946 2.00 


0.50 




1947 2.00 


0.25 


Voting Rights 


One vote per share. 




Restrictions 


Consent of | of Class A then outstanc 


ing require 



increase issue of Class A or common. 



Pre-emptive Rights 



Liquidation 



None for either class; yet in 1936 subscription rights 
for new common v^ere offered to each class at the same 
subscription ratio. 

Each share of Class A and of common is entitled to the 
same payments, unless in the case of voluntary liquida- 
tion the holders of more than \ of the then outstand- 
ing Class A object in writing within a period of 20 
days. 



310 Case Problems in Finance 

Exhibit 2 

CURTISS-WRIGHT CORPORATION 

Price Range on Class A and Common Stocks 

^ Price Range ^ 

Year Class A Common 

1932 3i- H 3i- I 

1933 8-2 4f-li 

1934 12i- 5i 5i-2i 

1935 12i- 6i 4f-2 

1936 21|-10i 9i-4 

1937 231- 8i 81-2 

1938 28i-12f 7|-3i 

1939 32i-19i 13i-4i 

1940 32i-2U llf-6i 

1941 29i-24 10i-6| 

1942 , 251-18 9i-5| 

1943 24^-141 9^-5i 

1944 19i-14| 7i-4| 

1945 30i-18i 9 -5i 

1946 34i-17i 12i-5| 

1947 1st quarter 20i-18| 6i-5i 

2nd quarter 19 -12| 5|-4i 

3rd quarter 19i-14i 5|-4| 

4th quarter 2 U-l6i G -A\ 

1948 1st quarter 24^-18^ 6|-4i 

chased for cash. Discussing these acquisitions in 1947, Mr. Vaughan 
stated that any additional enterprises that might be acquired would be 
of a type with which the management was familiar. 

On November 3, 1947, the company issued a call for tenders for 
as many as 500,000 shares of Class A stock at $20.50 per share 
($10,250,000). This offer resulted in the redemption of 204,983 
shares at a cost of $4,215,684, of which amount $204,983 was applied 
in reduction of the par value of the Class A stock which was canceled 
and the balance was applied against earned surplus. In connection with 
the request for tenders, the company stated that it had not purchased 
any of its stock in the open market or otherwise. 

The backlog of research and production orders on hand in early 
1948, in the opinion of the management and the opposition committee, 
was sufficient to assure profitable operations for more than a year with- 
out consideration of anticipated new orders from commercial and gov- 
ernment sources. (As it developed, 1948 sales were about $112 million, 
and profits after taxes $5 million.) 



CuRTiss- Wright Corporation 



311 









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312 Case Problems in Finance 

Exhibit 4 

CURTISS-WRIGHT CORPORATION 

Consolidated Balance Sheets as at December 31 

(Dollar figures in thousands) 

ASSETS 

1946 1947 

Cash in banks $ 26,472 $ 10,908 

Government securities 60,450 64,616 

Accounts receivable 15,966 17,475 

Claim for refund 25,000 9,700 

Inventories 29,281 31,907 

Termination claims 8,539 1,381 

Total current assets $165,709 $135,987 

Prepaid expenses 423 294 

Plant facilities, net 19,318 25,369 

Real estate and machinery held for disposal 5,162 275 

Mortgages and investments 2,659 4,272 

Total assets $193,272 



LIABILITIES 

Accounts payable — trade $ 5,178 

Accrued wages and taxes 7,136 

Advances on contracts 10,662 

Accounts payable — United States government 931 

Provision for federal taxes 25,397 

Termination claims payable 3,765 

Other liabilities 2,289 

Total current liabilities $ 55,360 

Reserves : 

Service guaranty $ 4,600 

Insurance 200 

War and postwar contingencies 21,045 

$ 25,845 

Minority interest 1,630 

Capital stock: 

Class A stock — $1.00 par 1,159 

Common— $1.00 par 7,432 

Capital surplus 15,325 

Earned surplus 86,521 

Total liabilities $ 193,272 



$166,198 


$ 5,101 
4,015 
6,244 
1,291 
13,918 
754 
1,324 


$ 32,646 


$ 4,425 

200 

5,000 


1 9,625 
1,625 

954 

7,432 

15,347 
98,569 


$166,198 



PART 4 

PROMOTION, EXPANSION, 
COMBINATION 



VVIVVVUVVV\VVVVVVVIVVWVVVWVVVVVVVVVIMVVVVI\V\\VVVVVVV^^ 



Leary Motors 



IVWVVVVVVVVVVVVVIVV\VWVVVVVVA^VVV\VVVVVVVVVVVVWVVV\VVVVU^^ 

Mr. Paul A. Leary, a successful sales representative for a High Point, 
North Carolina, furniture manufacturer, had an opportunity in July, 
1946, to purchase a High Point automobile dealership on what he con- 
sidered favorable terms. After taking an option to buy the firm, he set 
about arranging to raise the $75,000 necessary to cover the purchase 
price of $60,000 and to provide needed working capital of $15,000. In 
the course of discussions about the financing of the enterprise, the ques- 
tion came up of whether the new firm would be operated as a proprietor- 
ship, a partnership, or a corporation. Mr. Leary felt that he should reach 
an early decision on the matter. 

Although his position in the furniture company necessitated travel 
for about three weeks out of each month, Mr. Leary managed to take an 
active part in the civic and social affairs of his community. At 55 he 
owned his home, worth $20,000, free of any lien. In addition to several 
life insurance policies with aggregate cash surrender value of $16,750, 
he owned approximately $15,000 of liquid funds plus some securities, 
currently worth about $8,000, which he desired to retain as investments. 
His two children, Paul, Jr., and Judy, were 26 and 23, respectively. His 
daughter was a college graduate employed as secretary to an insurance 
general agent in High Point. Paul, Jr., had left college in 1941 to enter 
the army, where he served as an infantry officer; he had been married on 
his terminal leave in the fall of 1945 and returned to finish his last year 
of college. He graduated in June, 1946, with a Bachelor of Arts degree 
in economics. 

Mr. Leary wanted to give his son an opportunity to prove himself as 
an administrator, but he also wanted to provide him with sufficient fi- 
nancial incentive to stay in High Point rather than to accept a position 
with a large textile firm in Greensboro. When he learned that the local 

315 



316 Case Problems in Finance 

dealer of one of the independent car manufacturers was contemplating 
retirement, Mr. Leary talked with him and took an option to buy the 
going concern. While this particular make of car had accounted for only 
a small segment of the market before the war, it had gained considerable 
popularity in the postwar market and was increasing its percentage of 
total passenger car sales. 

Although the retiring dealer had shown him tax returns for the past 
several years, Mr. Leary wanted to get some estimate of the future in- 
come possibilities of the dealership. He therefore contacted Mr. Jordan, 
district representative of the car manufacturer. The latter estimated an 
annual net profit for the dealership of approximately $10,000 before 
taxes but after allowing for a $5,000 salary to be paid to Paul, Jr. This 
seemed in line with Mr. Leary's estimates based upon what the retiring 
dealer had showed him. 

Having satisfied himself concerning the potential profitability of the 
dealership, Mr. Leary outlined his plans to the officers of a local bank 
where he was well known and highly regarded. He mentioned his desire 
to have his son manage the business on a salary basis and to have his 
daughter share equally with his son and himself in any profits. The bank- 
ers expressed a willingness to help with the financing of the new venture 
and suggested that it be incorporated to limit Mr. Leary's liability in view 
of his limited participation in the management. The bankers agreed to 
loan $60,000 on the condition that Mr. Leary invest $15,000 cash in the 
business. Of the bank's total participation $35,000 was to be secured by 
a mortgage on the building and fixtures, which were valued at $50,000; 
$10,000 was to be an unsecured note of the corporation or partnership 
endorsed by Mr. Leary; and $15,000 was to be a personal note signed by 
Mr. Leary. 

Mr. Leary was not completely satisfied that incorporation was a 
proper step. Later, during franchise negotiations with Mr. Jordan, he 
raised the question of the organizational form of his dealership. Mr. 
Jordan explained that his office received monthly operating reports from 
each dealer in the district. In this manner the manufacturer could con- 
trol adequately dealer activities, regardless of the form of individual 
organization. Mr. Jordan further pointed out that only one person, des- 
ignated as the dealer, signed the franchise agreement. Article 12 of this 
document stated: "This Franchise Agreement constitutes a personal 
contract, and Dealer shall not transfer or assign this Franchise or any 
rights hereunder. ..." 



Leary Motors 317 

Exhibit 1 
LEARY MOTORS 
North Carolina Resident's Income Tax Rates 
Brackets of Incremental 

Taxable Income Tax Rate 

0-$ 2,000 3% 

Next $ 2,000 4 

Next $ 2,000 5 

Next $ 4,000 6 

Over $10,000 7 

Exemptions : 

Single $1,000 

Married 2,000 

Each dependent 200 

Exhibit 2 

LEARY MOTORS 

Federal Personal Income Tax Rates 

Combined Normal and 
Brackets of Surtax Incremental Rates 

Taxable Income 1945 Act 

0-$ 2,000 19% 

$ 2,000-$ 4,000 21 

$ 4,000-$ 6,000 25 

$ 6,000-$ 8,000 28 

$ 8,000-$10,000 32 

$10,000-$ 12,000 36 

$12,000-$14,000 41 

$14,000-$ 16,000 45 

$16,000-$ 18,000 48 

$18,000-$20,000 50 

Exemptions : 

For taxpayer and each dependent, $500. 

In order to clarify his thinking about the form of organization for 
his new enterprise, Mr. Leary sought the advice of his lawyer, Mr. Riley. 
The counsellor first cautioned him to make certain that he had adequate 
insurance coverage for his property and for protection against claims and 
liabilities resulting from work done by men in the garage. In addition to 
adequate insurance Mr. Riley felt that the limited liability feature of 
corporate organization would be beneficial. He said it was desirable to 
incorporate in order "to operate the business as a distinct entity." Incor- 
poration, he pointed out, could be accomplished at a cost of about $250, 
including all fees and initial taxes. Furthermore, if at any time it might 
be desirable to divest the business of its corporate form, this could be 
done with very little trouble. Finally, Mr. Riley remarked that he be- 
lieved certain tax advantages would accrue as a result of incorporation. 



318 



Case Problems in Finance 



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320 Case Problems in Finance 

Mr. Leary felt that it would be inadvisable to operate the business as 
an individual proprietorship because the profits of the enterprise would 
be added for tax purposes to his average earnings of $14,000 annually 
from the furniture company (see Exhibits 1 and 2 [p. 317]). He was 
aware of the double taxation of corporate profits and individual income 
in the form of dividends paid from those corporate profits; however, he 
was not sure what other taxes his firm might incur as a corporation 
which it could avoid as a partnership. 

In view of the fact that debt would be substantial in relation to in- 
vested capital, Mr. Leary decided that initially 60% of any profits earned 
would be retained in the business. Additionally, Mr. Leary believed that 
there might be some question regarding an equal split of profits under 
any organizational form since he was putting up the entire equity capital. 
Nevertheless, he hoped that, if his son spent full time on the business 
and if his daughter acted in some official capacity, even part time, divi- 
sion of profits into three equal shares could be justified. 

After some research in the local library, Mr. Leary made some com- 
parative tax estimates (see Exhibit 3 tp. 318}). The estimates were 
based upon Mr. Jordan's income forecast and the facts that the personal 
income of Mr. Leary 's daughter was $2,000 and that his son had no 
other income than that which his job would yield. 



rt\v\A\VVVV\VVVV\VVAa\VWVVVVVVVWVVVVVVVVVVVVVVVV^^ 



Supra Development Corporation 



»VVVVVVVAA\VVVVVVVVVWV\VVVVVVVVVVVV\\V»/VVVV\M/^^ 

In early August, 1947, Mr. Stuart Hale faced the problem of how 
he and two associates should best finance the manufacture and sale of a 
new power wood- and metalworking tool. Work on the project had pro- 
gressed to a point where it appeared that the product was basically a 
good one, that it fulfilled an apparent need, and that it could be produced 
at a reasonable price. Preliminary investigations suggested a wide market 
acceptance. Mr. Hale felt that the time had come to give careful con- 
sideration to the financial aspects of promoting the new venture and how 
the financial aspects might influence the production and marketing 
plans. 

The product was the invention of Mr. Fritz Schneider. Mr. Schneider 
had been educated as an engineer in Europe. In 1937, he emigrated to 
America from his native Austria. On a total capital of about $500 he set 
up a woodworking business in Houston, Texas, to produce and sell sev- 
eral small consumer products which he had invented. The inventions 
were generally regarded as good ones and later were exploited success- 
fully in varying forms by other concerns. The business proved unsuc- 
cessful, however, and in 1939 Mr. Schneider accepted an engineering 
position with a local shipyard. 

His woodworking experience in the United States had convinced Mr. 
Schneider that there was a real need for a power tool which would com- 
bine the functions of a number of tools currently produced. He felt that 
the function of a lathe, circular saw, disc sander, and horizontal and 
vertical drill press could be combined in a single unit. Some such multi- 
purpose units had been attempted but had met with limited success. 
Those tools that had been produced were bulky; it took several minutes 
to change from one working setup to another, and for each use the tools 
were less satisfactory than individual tools for the purpose on the mar- 
ket. 

321 



322 Case Problems in Finance 

The end of the war, with resultant cuts in overtime work, gave Mr. 
Schneider more time to work on his idea. In the basement of his Houston 
home, he developed a small wooden model of a tool. By changing the 
setup of the tool, each of the five functions could be performed effec- 
tively. In January, 1947, he left his shipyard job and put his full time on 
a larger metal model. 

As his work progressed, he became convinced that he had success- 
fully overcome the problems that had prevented other multipurpose 
tools from being successful. Accordingly, he contaaed Mr. Tom Hale, 
a young businessman and former associate at the yard. Mr. Hale was 
only 28 years of age but had built up quite a reputation at the shipyard 
as an enterprising and able businessman. Since the war, Mr. Tom Hale 
had been associated with the promotion of a new product and had ac- 
quired considerable experience in this kind of work. 

After a study of the product, Mr. Tom Hale interested an older 
brother, Stuart, in it. Stuart Hale was also young, but he had achieved an 
outstanding record in college and at a graduate school of business ad- 
ministration. Following graduation he worked for a large New York 
department store before going on active duty with the quartermaster 
corps of the army. After the war, he had moved to Houston and under- 
took to expand the production and sales of an industrial product. Al- 
though he had been successful in building up the sale of this product to 
a degree, the produa was such that its maximum possibilities seemed 
limited. 

After much discussion the Hale brothers agreed to undertake to pro- 
mote Mr. Schneider's invention. It had been their experience that in- 
ventors often were inclined to underestimate the importance of the 
business aspects of getting a new product produced and on the market. 
Several inventors they had known seemed to have the idea that great 
profits almost automatically accrued to a successful inventor. They 
found, however, that Mr. Schneider appreciated the difficulties involved, 
and after some discussion they reached an agreement. Under the agree- 
ment a company would be formed with the common stock ownership 
shared equally by the three men. The administration would rest prima- 
rily with the Hales. Mr. Schneider, who was married and had a family, 
would receive a salary of $100 a week from March 1, 1947, and would 
spend his time on the improvement of the product and ultimately on 
development of new ideas. He had exhausted his personal funds in the 
development of the product to date and had no further resources to in- 



Supra Development Corporation 323 

vest in business. The responsibility for raising funds to finance the busi- 
ness would rest with the Hales. 

Before setting up the new business, and while retaining their other 
jobs, the Hales worked evenings and on week ends on the further devel- 
opment of the product. Through friends they learned of an engineer 
especially capable in production design. On April 1 5 this man was hired 
to work on the project. By July 1 the joint efforts of the production engi- 
neer and Mr. Schneider resulted in a second metal model, designed for 
ease of production as well as efficiency of operation. Detailed production 
drawings were also prepared. At this stage all concerned were convinced 
that the improved model was superior in each of its five major functions 
to the one-function power tools on the market and that it could be pro- 
duced at a reasonable price. 

Thereupon, early in July, 1947, the Hale brothers resigned their 
other positions and prepared to devote full time to the projea. They 
planned to draw no salaries until the business was firmly established. 

In an informal division of duties Mr. Stuart Hale decided to concen- 
trate on the problems in the marketing area and Mr. Tom Hale on pro- 
duction problems. Mr. Stuart Hale first turned to consideration of where 
the market lay for his product. A study of the sales of home tools, such 
as power lathes and saws, indicated that the principal buyers were home 
craftsmen. In garage or basement workshops these craftsmen undertook 
the building of furniture and other articles for the home both as a hobby 
and as a means of reducing the cost of home articles and home repairs. 
In addition to these amateur craftsmen, some carpenters and small con- 
tractors also purchased light power tools. 

His preliminary investigations suggested that the compactness, ease 
of use, and the feature of five basic tools, lathe, circular saw, disc sander, 
and horizontal and vertical drill press in one unit, would be major sell- 
ing points for the machine. After much discussion, the wife of Mr. Tom 
Hale thought of a name for the tool — "Quin-Craft" — which was 
adopted. At the same time it was decided to call the new corporation to 
be formed the "Supra Development Corporation." 

It appeared to the Hales that price would be very important in de- 
termining the extent of the potential market for the tool. It seemed 
highly desirable that the price for the Quin-Craft be significantly less 
than the combined price of the five individual tools. Since many of the 
home craftsmen were working men or relatively low-paid clerical peo- 
ple the price should be within their financial capacity. 



324 Case Problems in Finance 

Although they had learned of no competing multipurpose tools being 
developed, it was felt that a successful development of the tool would 
inspire competitors to enter the field. A high price with apparent high 
profits would encourage the development of such competition. On the 
other hand, the Hales were determined to produce a rugged, high-quality- 
product. Any weakness or failure in the product would, they felt, be dis- 
astrous to the new company. In addition, the cost of producing the Quin- 
Craft was highly uncertain. The fact that it was completely new with no 
cost experience available was one aspect of the uncertainty. The other, 
and perhaps more serious, problems arose out of the sharp increase in 
the general price level in later months, which showed no sign of taper- 
ing off. 

The consideration of price and its effect on the market potential 
raised the basic policy question of whether the company should attempt 
to take a high profit margin on a relatively small volume of sales or ac- 
cept a low and somewhat precarious profit margin in the hope of build- 
ing a large long-run market for their product. After much thought it 
was firmly decided to plan for a modest unit profit in the hope of a large 
and continuing volume of sales. 

To test market acceptance and estimates as to customer interest, ar- 
rangements were made with a local department store to let the Hales 
display one of the production models and take orders at a tentative price. 
The test sales met with a gratifying response. It became apparent, how- 
ever, that even at the lowest feasible price the product would require 
aggressive 'point-of -purchase" sales effort. The tool might "sell itself" 
in a few cases, but demonstration by trained personnel seemed essential 
to large sales. 

The next marketing question facing Mr. Hale was that of selection 
of channels of distribution. Obvious possibilities were sale through re- 
gional chain stores, such as the Western Auto Supply stores, or through 
large mail-order houses, such as Sears, Roebuck «& Company. The mail- 
order chains had the advantage of national distribution. His preliminary 
investigations of the market indicated that mail-order catalogue sales 
would be small and that the demonstration and aggressive selling the 
product needed could best be obtained through the retail stores main- 
tained by the mail-order house. Each of the largest chains maintained a 
number of retail outlets, although the coverage of each company was 
somewhat spotty. As an illustration of the lack of coverage of many 
metropolitan areas, none of the large chains had a retail store in New 



Supra Development Corporation 325 

York City or Seattle, Washington. Mr. Hale had heard a lot of contro- 
versy over the desirability of selling through the mail-order companies. 
In his view they could be counted on for very aggressive merchandising, 
but he knew of their reputation for shrewd and sometimes hard bargain- 
ing with their suppliers. On the other hand, their credit was unques- 
tioned, and they would pay approximately 20 days after invoices for 
material shipped them were received. 

The local regional buying offices of two of the principal mail-order 
houses were contacted. The regional buyers of each company expressed 
real interest in the product. Each made clear, however, that his company 
would consider handling the item only on an exclusive basis in the cities 
in which they had retail outlets. Neither would take it if the other mail- 
order company also sold Quin-Craft. 

Large department stores also represented logical channels of distri- 
bution. It was thought that by granting an exclusive franchise to a large 
department store in each of the major cities of the country, the aggres- 
sive selling efforts of these stores could be secured. Sale through depart- 
ment stores would have the advantage of not basing all the company's 
fortunes on its relationship with a single firm since for the most part the 
department stores were owned and operated as independent units. On 
the other hand, to contact and sell the widespread department stores 
would require a much larger sales organization and much more travel 
expense than would be necessary in dealing with a single mail-order 
company. Furthermore, a larger inventory might well prove necessary 
in order to meet promptly the orders of many department stores, and 
the collection period on accounts receivable would probably average 
40 days. 

In planning a sales program Mr. Hale was conscious of a degree of 
time pressure. It seemed essential to get the product on the market and 
established during a period of economic prosperity such as currently pre- 
vailed. Also, it seemed highly advantageous to get the initial impetus to 
sales that would be provided by getting the product on the market in 
time for the 1947 Christmas selling season. 

While Mr. Stuart Hale was considering marketing possibilities, Mr. 
Tom Hale was concerned with the problem of how best to produce the 
tool. An initial question was: Should Supra Development Corporation 
attempt to manufacture the Quin-Craft or should it have other com- 
panies make it? It appeared clearly desirable for Supra to purchase some 
component parts such as castings and the ^ hp electric motor which 



326 Case Problems in Finance 

provided the power for the tool and saw blades. Consequently, the prob- 
lem resolved itself into one of complete subcontracting of production 
and assembly or of production of simpler parts and assembly by the 
company. Assembly by the Hales would mean that a plant would have 
to be leased or purchased. Some machinery and other plant equipment 
would have to be bought. Mr. Tom Hale talked with some industrial 
real estate agents and discovered a plant, roughly adequate for at least 
the first months' probable requirements, that could be purchased for 
what appeared to be a very reasonable price of $100,000. However, 
some alterations in the building would be desirable. They would cost 
around $20,000. If operations were restricted to assembly, the necessary 
equipment could be purchased for between $20,000 and $30,000. It 
was thought that adequate labor and supervisory personnel could be 
recruited. 

Mr. Hale had talked to officials of several local concerns about the 
possibility of their handling production and assembly on a contract basis. 
Several indicated that they had all the work they could handle at pres- 
ent; but officials of a large ship repair company. Gulf Coast Marine 
Repair, Inc., expressed serious interest. Officials explained that they 
had considerable excess capacity and were considering use of their facil- 
ities for other than marine repair work. They reviewed the plans care- 
fully and expressed the conviction that they could produce the Quin- 
Craft for what the Hales regarded as a reasonable price. They would 
require, however, that Supra pay for certain tools that Gulf Coast would 
need to be able to make the Quin-Craft. Estimated cost of these was be- 
tween $6,000 and $10,000. Also, general shortage of many basic raw 
materials for the Quin-Craft had been developing since the war; and the 
ship repair company stated that the Hales would have to provide the 
necessary raw materials and components, such as the electric motor, to 
be purchased outside. Despite the general steel shortage, however, the 
supply of bar steel and pig iron for castings which would be used in the 
Quin-Craft was not yet critical. 

Subcontracting promised substantial advantages from a time stand- 
point since the ship repair firm estimated that they could be ready for 
quantity production by November 1, 1947. After talking to friends in 
production jobs, Mr. Hale concluded that it would take Supra at least 
until January 1 to set up its own production organization and facilities. 

It was at this stage of the development of the project that Mr. Stuart 
Hale decided to focus attention on the financial aspects of the plans. 



Supra Development Corporation 327 

Both he and his brother until this date had rather assumed that the fi- 
nancial aspects could be worked out satisfactorily after production and 
marketing plans had been made. Mr. Stuart Hale had no experience in 
finance beyond classroom work in school. When he sat down to estimate 
the financial requirements for the program, he was somewhat dismayed 
at the size of the possible financial need and the wide range in amounts 
needed under the various alternative programs of manufacture and sale. 

The amount required for investment in fixed assets obviously would 
be greatly influenced by the decision as to subcontracting. If the com- 
pany bought its own plant the need for funds was sharply increased. 
Regardless of how much the company subcontracted, some $6,000 would 
be required for transportation and ofiice equipment. It was estimated 
that $8,000 would have been spent in the development of the product 
and at least $3,000 in preliminary marketing expense. It would cost 
around $500 to organize the new corporation. In addition it would be 
necessary to recruit a secretary in the near future and to hire a shipping 
clerk, a bookkeeper, and other ofiice help before sales began. For the 
present neither of the Hales planned to draw a salary. 

The amount of money required for working capital also appeared to 
be very much dependent upon the choice of marketing and production 
arrangements. Some investment in inventory would be required under 
any plan. In addition, an investment in accounts receivable could be 
avoided only if the company were to sell for cash. Also the company 
would have to carry some cash in a bank account so as to have cash 
available in the event of emergencies, such as strikes or shipping tie-ups. 

Under any of the alternative production arrangements, some in- 
ventory would have to be maintained at the expense of Supra. If the 
production job were contracted, it was expected that Supra would pro- 
vide only accessories such as the electric motor. In order not to delay 
work by the contractors a supply of these accessories would have to be 
maintained at the plant. In view of the possibilities of subcontractor 
strikes, material shortages, and other interruptions to continuous flow of 
accessories, it seemed desirable from a production standpoint to carry a 
stock of as much as a month's supply of these accessories. Although at 
this time estimating the unit cost of the accessories and the volume of 
production was difficult and vague, Stuart Hale was thinking in terms of a 
volume of 900 units a month in the first months and a unit cost of about 
$30 for accessories (including the relatively expensive electric motor). 
Under subcontracting arrangements an investment in other raw mate- 



328 Case Problems in Finance 

rial and in work in process would be avoided. If Supra Development 
Corporation undertook to produce Quin-Craft itself, an additional in- 
vestment in raw materials, perhaps $10 a unit, would be required. It 
was expected that the production and assembly process would take about 
10 days. 

Under any production arrangement some inventory of finished 
Quin-Crafts would ultimately be required if the company were to fur- 
nish prompt shipment as orders were received. For the first few months, 
however, under the ideal distribution setup, orders would exceed pro- 
duction and hence an investment in finished goods inventory would be 
limited to one or two days' production in process of inspection and ship- 
ment. Total manufacturing cost of finished Quin-Crafts at present price 
levels promised to be between $75 and $85 a unit without motor. The 
motor would add an additional $20-$ 30 in cost. 

The required investment in accounts receivable would vary with 
the terms that could be worked out with distributors selected; but Mr. 
liale tended to think in terms of an average of one month's sales on the 
company's books at any one time, if sales were made through a mail- 
order house, and about 40 days if sales were made to scattered retailers. 
At the end of the first month of sales, however, receivables would equal 
one month's sales under any of the plans. 

In an effort to translate his ideas into some sort of estimate of the 
investment needed, Mr. Hale brought them together in the form shown 
in Exhibit 1 (p. 330) . He chose to picture the investment that might be 
required after about one month of full operations. He chose this date 
since he felt this would likely be the time of greatest "strain" financially. 
At this time commitments would be great and proceeds of sales would 
not yet have been received. 

His estimates of accounts payable and accrued expenses were par- 
ticularly rough and were based on the hope that the company could get 
about one month's trade credit from both the suppliers of accessories or 
raw materials and the contractor, if one were used. In preliminary dis- 
cussions with the Gulf Coast Marine Repair Co., no mention had been 
made of credit terms, but he felt that credit could be arranged if the 
Supra Development Corporation could present a reasonably "healthy" 
financial statement. 

Since his figures were at best uncertain estimates, Mr. Stuart Hale 
drew up maximum and minimum estimates under the two major sets of 
assumptions indicated in the exhibit* Actually, these did not represent 



Supra Development Corporation 329 

full ranges of what might be required, but he thought they were suffi- 
cient for the purpose of seeing in very rough terms the amount of funds 
to be raised to finance operations under the major alternatives. 

His estimate of 900 units produced and sold in the first month was 
obviously not a precise one. He realized that, to the extent that actual 
production and sales experience proved different from his estimates, 
capital requirements would be altered. Further, if prices should continue 
to rise, the estimates would have to be revised upward. As plans became 
more definite, Mr. Hale expected to be able to sharpen his estimates and 
perhaps to make up some cash budgets based on fairly definite plans. 

The next major financial question was how best to meet the possible 
financial needs. Mr. Schneider had no personal resources and under the 
original agreement was entitled to one-third ownership of the company 
in return for his invention. Mr. Stuart Hale had some $14,000 in sav- 
ings which he had accumulated, most of which was currently invested in 
readily marketable stocks and in war bonds. Mr. Tom Hale had recently 
used all of his savings to purchase a home in a near-by suburb. However, 
it was owned outright and could be mortgaged for about $15,000. The 
costs of development to date, together with Mr. Schneider's salary, had 
been met from the Hales' savings. The Hales' parents expressed a will- 
ingness to invest as much as $20,000 of their savings in the concern on 
a temporary basis. However, both of the sons realized that their venture, 
like most new businesses, was a risky one. Consequently, they hesitated 
to commit resources of their parents, which had been accumulated as 
security for their old age, to the enterprise. 

Mr. Stuart Hale had given some thought to possible sale of pre- 
ferred or common stock. Among his friends were some men of consider- 
able wealth, who, he felt, would buy stock in the new concern. However, 
any common stock sold would have to be out of the two-thirds allocated 
to the Hales. This would reduce their control over the company and 
would limit the return. 

Stuart Hale knew of a few new concerns which had been able to sell 
small amounts of preferred stock. This stock could carry a fixed dividend 
rate of 6 % or 7 % and seemed a possible answer to the problem of rais- 
ing funds. However, upon investigation he found that his friends were 
interested in investing in his venture only on a common stock basis. 
They argued that preferred stock offered almost as much risk in situa- 
tions of this sort as the common without the possibilities of large return 
if the company succeeded. From his preliminary discussions, Mr. Hale 



330 



Case Problems in Finance 



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Supra Development Corporation 331 

concluded that preferred stock could be sold only if a substantial block 
of common were offered to the purchasers of the preferred stock. Fur- 
thermore, registration of stock with the state authorities often required 
several weeks' time and considerable paper work. He also considered the 
possibility of issuing bonds but it appeared that it would be hard to in- 
terest investors in the bonds of a new and small company. However, if 
the plant were purchased it was thought that a mortgage of at least 
$50,000 could be secured against the plant. 

At this stage, Mr. Hale visited a friend who was a vice-president of 
the Texas National Trust and Savings Association, a bank which had 
the reputation of being progressive and of encouraging new companies. 
Mr. Clark, the banker, listened to Mr. Hale's plans with interest. Mr. 
Clark explained that the bank had to be very careful about loaning to 
new unproved companies. In some cases, however, the bank had ad- 
vanced funds for a portion of the working capital requirements of new 
concerns provided they had careful and complete plans by which they 
could demonstrate an ability to repay the loans in a relatively few 
months. 



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Buckeye Mold & Tool Company 



In January, 1947, the management of Buckeye Mold & Tool Com- 
pany was faced with the problem of formulating a financial program 
for the current year. 

Buckeye Mold & Tool Company was incorporated in January, 1945, 
by Jack Chase and Elmer Sorenson, toolmakers in the mold department 
of the Akron Rubber Company. Molds were used to form specialty rub- 
ber products, such as toys, industrial parts, fountain pens, hot-water bot- 
tles, and a variety of other items. The life of a mold depended upon the 
simplicity of its design and the tolerances specified for the part that was 
to be molded. A mold for a simple part might last through three or four 
months, whereas an intricate mold might have to be discarded after two 
or three weeks of use. Throughout the war there was an inadequate sup- 
ply of rubber molds because of the shortage of skilled labor. It required 
many years of training to produce a qualified mold maker. 

The Akron Rubber Company, in common with most other specialty 
rubber companies, operated its own mold department. In times of nor- 
mal or peak demand, however, part of its requirements was obtained 
from independent mold and tool companies. 

Jack Chase had noted the high prices and the poor quality of the 
molds supplied his company during the war. He was convinced that if 
he could raise enough capital to start a small plant he would have no 
difficulty in getting a profitable volume of orders. In January, 1945, 
Chase and his brother-in-law, Sorenson, pooled their savings of |7,500 
and formed Buckeye Mold & Tool Company. 

The company started operation in the basement workshop of Soren- 
son's home, which was located in Pleasantville, Ohio, about 20 miles 
from Akron. As Chase had anticipated, no difficulty was experienced in 
obtaining orders. The company started with four customers, each a large 
manufacturer with a high credit rating. About $6,000 of the initial cap- 
ital was invested in secondhand machinery. Materials and supplies were 

332 



Buckeye Mold & Tool Company 333 

purchased in small quantities as they were needed. All the labor was 
performed by Chase and Sorenson, with the assistance of the latter's 
18-year-old son, an able machinist. Chase's wife attended to the office 
work and bookkeeping. 

The company soon found itself in need of additional capital to fi- 
nance inventory and to pay for small tools and heat treating. In May, 
1945, $2,000 was borrowed from Chase's mother, with the promise that 
the money would be repaid at the earliest opportunity. 

In the summer of 1945 it became apparent that additional financing 
was needed. The basement workshop was proving inadequate for the 
volume of business that could be handled. In August an arrangement 
was negotiated with the Pleasantville Trust Company whereby the latter 
agreed to lend the company $10,000 on 90-day, 6% notes secured by a 
chattel mortgage on machinery and second mortgages on Chase's and 
Sorenson's homes. Later that month $15,000 was spent on the purchase 
of a small building into which the machinery was moved. A $7,400, 
5%, 5 -year mortgage on the building was arranged with the Pleasant- 
ville Savings and Loan Association. After moving to the new building, 
several machinists were added to the payroll. The new employees were 
carefully selected from among the best men with whom Chase and 
Sorenson had worked in the past. 

New machinery and employees were added from time to time. The 
purchases of the new machinery were financed with the aid of loans 
from the Pleasantville Trust Company secured by chattel mortgages. By 
November, 1945, the company owed the bank $20,000. In that month. 
Jack Chase, who handled administrative matters, was introduced by Mr. 
Leib, loan officer of the Pleasantville Trust Company, to Mr. Phillips, 
a vice-president of the Mammoth National Bank of Cleveland. In the 
course of their conversation Mr. Phillips indicated that as a "starter" his 
bank would be willing to lend the company up to $5,000 on notes se- 
cured by chattel mortgages. Chase had, however, no immediate need for 
such a loan. 

The company's first year proved profitable. Earnings before income 
taxes were $19,580 on sales of about $38,000. See Exhibits 1 and 2 for 
financial statements. The company had acquired 10 customers, all major 
concerns, which were ready to supply the firm with all the orders it could 
handle. Buckeye Mold & Tool had won a reputation in the trade for 
high-quality workmanship. 

The company continued to grow during its second year. A $3,000, 
6%, 90-day note for the purpose of purchasing machinery was placed 



334 Case Problems in Finance 

with the Mammoth National Bank in February, 1946. At the time the 
loan was made, Mr. Phillips offered the firm a line of $25,000 to be se- 
cured by pledge of the accounts receivable. Interest was to be at the rate 
of 5%, plus a service charge of 2%. Advantage was not taken of this 
offer. Instead, as sales and profits increased. Chase was able to borrow 
additional money from the Mammoth bank on the same 6%, 90-day 
terms as the original $3,000 loan. In February, 1946, the notes held by 
the two banks, which had reached a total of $43,000, were combined 
into a single note secured by a blanket chattel mortgage on the machin- 
ery. It was understood that the Mammoth National Bank held a 50% 
participation in the new note. The second mortgages held by the Pleas- 
antville Trust Company on Chase's and Sorenson's homes were relin- 
quished. 

In the three months from August to November, 1946, the company 
repaid $12,000 to the banks and the $2,000 borrowed from Chase's 
mother. In November an additional $4,000 was borrowed from the 
Pleasantville Trust Company on a 90-day note, secured by a chattel 
mortgage, for the purpose of purchasing machinery. Chase negotiatec? 
this note at a 5^% interest rate on the strength of the company's im- 
proved financial condition. 

In the fall of 1946 Chase persuaded Sorenson that it would be prof- 
itable to take orders for mold frames. Frames were used to hold molds 
in the press during the molding process. A frame would last about six 
months and did not require highly skilled workmanship. Plans were 
made for enlarging the company's plant to handle frame produaion. 
Late in December, however, the Pleasantville zoning board ruled against 
permitting the proposed construction. 

In January, 1947, Chase approached Mr. Leib with plans calling for 
the purchase of a suitable plant which had just become available, the 
building and land to cost $60,000. Chase also wanted to spend $40,000 
on new machinery to be used for expanding mold production and for 
the manufacture of frames. He asked Mr. Leib if his bank would be will- 
ing to finance these purchases and, in addition, grant a $50,000 line of 
credit for working capital purposes. Mr. Leib stated that the Pleasant- 
ville bank could not make so large a commitment but that he would dis- 
cuss the proposal with Mr. Phillips. Several days later Mr. Leib and Mr. 
Phillips called on Chase. Mr. Phillips expressed satisfaction with the 
company's progress but cautioned against a disproportionately large in- 
vestment in fixed assets, especially if financed by borrowing. Mr. Phil- 
lips stated that his bank was willing to continue to renew its portion of 



Buckeye Mold & Tool Company 335 

the note and to lend additional funds for working capital needs and es- 
sential additions to plant and equipment. He did not, however, believe 
that it would be advisable for the bank to lend money for the purchase 
of a new plant or for expansion into the frame business. 

Following his conversation with Mr. Phillips, Chase discussed his 
plans with Mr. Weil, Cleveland branch manager of the Acme-National 
Credit Corporation, a finance company. Mr. Weil expressed interest and 
stated that his company might be willing to finance the program. Mr. 
Weil said that it would probably be possible to work out a 6%, $40,000 
mortgage on the new building, to be repayable in 10 annual install- 
ments. In addition he would consider a revolving loan to be secured by 
pledge of the receivables. The revolving loan would be at 6% rate of 
interest plus a 3 % service charge. Additional needs could be financed by 
8% notes secured by chattel mortgages on machinery in an amount 
equal to a maximum of 80% of the purchase price, by assignment of 
the inventory and by second mortgages on the partners' homes. 

Chase also approached the Pleasantville Savings and Loan Associa- 
tion, which expressed interest in taking a $35,000, 5^% mortgage on 
the proposed new building, the loan to be amortized in 1 5 years. 

Chase and Sorenson were debating the advisability of going through 
with their expansion plans when they received their statements for the 
year ending December 31, 1946. (See Exhibits 1 and 2.) Sales in the last 
quarter had averaged $25,000 a month, and had been distributed among 
15 accounts. 

To assist himself and Sorenson in formulating financial plans for 
the coming year. Chase prepared several estimates. If they remained in 
their current building, he estimated that sales for 1947 would total 
around $325,000 and profits before income taxes, $120,000. Under 
current laws, federal income taxes for corporations earning over $50,000 
would be at the rate of 38%. If the proposed plant and machinery pur- 
chases were made and the manufacture of mold frames undertaken, 
Chase estimated that sales for the year would total $600,000 and profits 
would be $210,000 before income taxes. Estimates of sales and profits 
were based on the assumption that demand for molds and frames would 
continue at about the current rate. 

Selling terms on frames would be the same as for molds, net/30 
days. It was estimated that raw materials inventory would double if the 
proposed expansion were undertaken, while work in process would be 
related to sales volume in about the same ratio as currently. It was 
thought that the building and land owned could be sold for $20,000. 



336 Case Problems in Finance 

Exhibit 1 

BUCKEYE MOLD & TOOL COMPANY 

Balance Sheets 

ASSETS 

Dec. 31 Dec. 51 

1945 1946 

Cash $ 504 $ 151 

Accounts receivable 2,042 37,740 

Inventory: 

Raw 656 2,040 

In process 1 1,012 30,454 

Prepaid expenses 465 12,606 

Total current assets $14,679 

Fixed assets: 

Machinery and equipment 

Less : Reserve for depreciation 

Net 

Buildings 

Less : Reserve for depreciation 

Net 

Land 

Other assets 

Total fixed assets 42,897 

Total assets $57,576 

LIABILITIES AND CAPITAL 

Accounts payable $ 359 

Accrued expenses 3,237 

Notes payable 19,500 

Reserve for taxes 5,275 

Accrued interest 

Accrued wages 

Total current liabilities $28,371 

Mortgages 7,400 

Capital stock 7,500 

Surplus 14,305 

Total liabilities and capital $57,576 



Exhibit 2 
BUCKEYE MOLD & TOOL COMPANY 

Income Statements 

1943 1946 

Sales $38,000 $256,220 

Cost of sales 14,330 124,947 

Depreciation 1,430 4,300 

Gross profit $22,240 $126,973 

Selling and administrative expenses 2,660 19,576 

Net profit from operations $19,580 $107,397 

Other expenses 1,453 

Federal income taxes 5,275 40,400 

Net profit $14,305 $ 65,544 



$ 82,991 


$ 73,680 
4,740 


$ 68,940 
15,300 

770 


$ 14,530 

11,515 

2,367 


$ 97,352 


$180,343 


$ 834 

4,746 

35,000 

43,275 

282 

2,386 


$ 86,523 

6,200 

7,500 

80,120 


$180,343 



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Cambridge Metal Products, Inc. 



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In November, 1944, the officers of Cambridge Metal Products, Inc., 
were studying possible methods of financing the purchase of Precision 
Forgings Company, a transaction currently under consideration. 

Cambridge Metal Products, Inc., manufactured metal specialties. Its 
products prior to World War II consisted of accessories for automobile 
bodies and interiors. About 80 % of dollar sales in peacetime were made 
direct to automobile manufacturers and the remainder to jobbers and 
large retailers. Four principal customers normally accounted for nearly 
40% of volume, with different divisions of large manufacturing com- 
panies constituting separate purchasers. The automobile accessories busi- 
ness was highly competitive, with competition coming from automobile 
manufacturers themselves as well as from suppliers. Nevertheless, in the 
nine-year period from its reorganization in 1933 through 1941, Cam- 
bridge Metal Products' sales had increased 600 % . 

Prior to its reorganization Cambridge Metal Products, Inc., had been 
controlled by Mammoth Machinery Corp., a large concern engaged in 
the manufacture of industrial machinery. Cambridge Metal Products, 
Inc., had had an indifferent record until the depression, when substantial 
losses forced it into bankruptcy and wiped out its stockholders' equity. 

Active in the reorganization proceedings were several partners in 
Vassall and Company, an old-established firm of investment bankers 
which specialized in the underwriting of municipal bonds and high- 
grade industrial securities. These men, who were friends of Alan Curtis, 
president of Cambridge Metal Products, Inc., invested a moderate sum 
of their personal money in a block of the reorganized company's stock. 
Due to their persuasion, Samuel Prescott, director and officer of a num- 
ber of concerns, also invested some money in the company and accepted 
the position of vice-president. Amos Breed, a director of several organi- 
zations in which Vassall and Company had interests, was appointed 

337 



338 Case Problems in Finance 

treasurer. Mr. Prescott and Mr. Breed devoted only part of their time to 
Cambridge Metal Products, Inc. The routine duties of the treasurer's 
office were performed by an assistant selected by Mr. Breed. 

Mr. Curtis, an able salesman with valuable contacts in the automo- 
bile industry, was retained as president. A large share of responsibility 
for management was given, however, to Howard Putnam, an energetic 
young engineer who had resigned his position with a large automobile 
manufacturer to go with the company as assistant production manager 
in 1930. Following the reorganization, Mr. Putnam thoroughly revised 
the company's managerial personnel and policies and modernized its 
plant and equipment, while Mr. Curtis concentrated on selling and on 
managing the sales department. Mr. Putnam frequently called on Mr. 
Prescott and Mr. Breed for advice on financial and other matters. Both 
had a wealth of business experience, much of it gained in helping con- 
cerns which were in financial difficulties. 

Thanks to the combined efforts of these men, sales and profits, which 
had been lagging behind the rest of the automobile accessories industry, 
began to show marked increases (see Exhibit 1 [p. 343]). The com- 
pany's financial condition improved sufficiently to allow dividend pay- 
ments of 45 cents a share in 1936, 60 cents annually from 1937 
through 1939, and 90 cents thereafter. 

Early in 1941 Mr. Curtis retired and his son was placed in charge of 
sales. Howard Putnam succeeded to the presidency. The principal effect 
of these changes was that Mr. Putnam devoted more of his time to the 
sales department and took a greater interest in product design. 

Following the cessation of civilian automobile manufacture in 1941, 
Cambridge Metal Products, Inc., devoted itself exclusively to war pro- 
duction. Part of its wartime output consisted of accessories for military 
vehicles, and the rest consisted of various metal parts and assemblies. 
War production necessitated no significant change in plant, equipment, 
or methods of manufacture. Such special machinery and equipment as 
were required were supplied by the purchaser without capital expendi- 
ture by Cambridge Metal Products, Inc. Output was increased chiefly 
through lengthening the workweek and through two-shift operation. 
Wartime working capital needs were supplied by increased earnings and 
by advances from government agencies and prime contractors. See Ex- 
hibit 2 for 1944 balance sheet. 

In 1942 the production of plastic rods and bars was started as a 
means of stabilizing earnings by diversifying output. Selling efforts were 



Cambridge Metal Products, Inc. 339 

directed to jobbers in the Boston area. Plastics volume in 1944 was 
$350,000. A research department was created in 1943 for the purpose 
of developing new products. At the end of 1944 developmental work 
was being completed on a two-wheel trailer-wagon designed for farm 
use. 

Early in October, 1944, Mr. Pr escort was visited by William Howe, 
a vice-president of the Milk Street Bank and Trust Company of Boston, 
an institution with which the company had had no previous dealings. 
Mr. Howe had come to offer for sale 95% of the capital stock of Preci- 
sion Forgings Company, one of his bank's depositors. Mr. Howe, a direc- 
tor of Precision Forgings Company, represented a group consisting of 
stockholding officers of the company and the Milk Street Bank as trustee 
for several estates which owned about 85 % of the capital stock. 

Precision Forgings Company, located in Watertown, Massachusetts, 
manufactured high-grade forgings. About 90% of its volume consisted 
of parts for steam and Diesel locomotives and the remaining 10% of 
automobile parts. A large proportion of the company's locomotive parts 
sales, especially in times of depression, were made direct to the railroads 
for repair and replacement. 

By reason of superior technical skill. Precision Forgings Company 
held a dominant position among its competitors. During the preceding 
decade, however, the company had not experienced the growth of which, 
in Mr. Howe's opinion, it was capable. Failure to live up to potentialities 
was attributed by Mr. Howe to the protracted illness of the president, 
James Warren. Mr. Howe also thought that majority ownership of its 
stock by estates had had a restrictive influence on company policy, en- 
couraging management to concentrate on the earning of current divi- 
dends to the neglect of long-term growth. 

It was the opinion of Mr. Howe and the officers of Precision Forg- 
ings Company that affiliation with an aggressively managed concern 
would furnish the impetus their organization lacked, whereas continued 
absence of able direction at top levels would eventually lead to a long- 
term decline. From his knowledge of its accomplishments, Mr. Howe 
was confident that the management of Cambridge Metal Products, Inc., 
was capable of supplying the energy and direction that Precision Forg- 
ings Company needed. 

After listening to Mr. Howe and studying Precision Forgings Com- 
pany's balance sheet and summary of earnings ( see Exhibits 3 and 4 ) , 
Mr. Prescott inquired about price. Mr. Howe replied that the holders he 



340 Case Problems in Finance 

represented would sell to the right buyer for $120 a share. The remain- 
ing 5% of the stock was distributed among some 25 individuals, most 
of whom, he thought, could be persuaded to sell at about the same price. 

Mr. Prescott surmised from the conversation that, by "the right 
buyer," Mr. Howe meant someone who would continue to operate the 
business after the sale and who would give the current management an 
opportunity to remain with the organization. 

Having conveyed the group's proposal, Mr. Howe added that his 
bank would be willing to arrange a term loan to finance the transaction. 
Although the bank would not be prepared to take the whole of such a 
loan itself, he was confident that the Cordwainers Society for Insurance 
on Lives would be interested in taking part of it. The current annual 
interest rate for comparable loans was about 4 % for maturities of up to 
five years, and 4^% for maturities of from five to ten years. 

Following Mr. Howe's visit, Mr. Prescott made a study of Precision 
Forgings Company. He learned that its management below top levels 
was considered good, and that most of its officers were competent, al- 
though none was outstanding. Mr. Prescott called on a number of rail- 
road purchasing agents and found that the company enjoyed an excel- 
lent reputation based both on fair dealing and the high quality of its 
product. Unusual confidence was expressed in its technical staff, gener- 
ally considered the best in the industry. Mr. Prescott also ascertained that 
foreseeable changes in locomotive design would not be likely to elimi- 
nate the need for high-quality forgings. Inquiries were made about the 
plant, and it was learned that it was kept in good repair. A large propor- 
tion of the company's machinery was thought to be over 15 years old 
but was evidently in good operating condition. The plant had not under- 
gone any wartime conversion because the same products were being pro- 
duced as in peacetime. Mr. Prescott also learned that there had been a 
shortage of unskilled labor since the war and that for that reason the 
plant was currently operating at less than three-fourths of capacity. 

Having satisfied himself that the proposal merited consideration, 
Mr. Prescott discussed it with Amos Breed, the treasurer. The latter 
agreed that Precision Forgings Company appeared to be an attractive 
"buy" at $120 a share and that the company would benefit greatly from 
Mr. Putnam's direction. Mr. Breed pointed out that the purchase would 
be in accordance with the policy of stabilizing earnings by diversifying 
sales. He added that, in his opinion, the combined companies would be 
large enough to sell securities to the public on a favorable basis as a 
means of financing the purchase. 



Cambridge Metal Products, Inc. 341 

Following their discussion, Mr. Prescott and Mr. Breed presented 
Mr. Howe's proposal to Howard Putnam. The latter's reaction was 
mixed. He admitted that it seemed like a good buy, but he had a number 
of reservations as to the purchase. 

For one thing, Mr. Putnam suspected that purchase of Precision 
Forgings Company might absorb so much of Cambridge Metal Products' 
financial resources as to prove an obstacle to establishing a plant in the 
Midwest, which he had for some time thought of as possibly being de- 
sirable. New England, he felt, was not keeping pace with the industrial 
growth of the nation. Moreover, Boston was far removed from the cen- 
ter of the automobile industry; the majority of the company's competi- 
tors and customers were located in the Midwest. In the discussions at 
board meetings, Mr. Putnam had stated that one advantage of a branch 
plant in the Great Lakes area would be a reduction of shipping costs and 
time. He believed that a Midwest plant, if it were acquired, should be 
used to produce accessories for the automobile industry, while the Cam- 
bridge plant would be devoted to plastics and new products. Mr. Putnam 
anticipated that, at the end of the war, defense plants and machine tools 
would become available for purchase on favorable terms. He estimated 
that the new plant would call for an expenditure of from $300,000 to 
$350,000. 

He also expressed concern about the possibility of a term loan be- 
cause of the covenants which the insurance company would probably try 
to impose. These provisions usually restricted a company's right to pur- 
chase property and to borrow money. Furthermore, he had reservations 
about a public issue of securities. Mr. Putnam had invested and was con- 
tinuing to invest the greater portion of his personal funds in Cambridge 
Metal Products' shares. The shares were closely held and seldom traded, 
though blocks of stock became available from time to time. The direc- 
tors had voted to sell treasury stock to Mr. Putnam at current book value 
on several occasions when he had been unable to buy any through his 
brokers. Over the years Mr. Putnam had accumulated a 1 5 % interest in 
the company, and he did not wish to see his interests as a stockholder 
damaged or his dividends reduced. 

Lastly, Mr. Putnam was worried about the long-run financial effect 
on the company of a purchase of this size. Precision Forgings Company 
was larger than Cambridge Metal Products, Inc., and he recalled several 
instances in which prosperous concerns had gotten into difficulty 
through less ambitious expansion. 

Despite his misgivings, Mr. Putnam expressed confidence in the 



342 Case Problems in Finance 

judgment of Mr. Prescott and Mr. Breed, especially in financial matters, 
and he terminated the conference with a request that Mr. Prescott inves- 
tigate the feasibility of financing the purchase through a public issue of 
securities. 

A week later Mr. Prescott reported to Mr. Putnam that he had dis- 
cussed informally with several investment bankers the possibility of a 
public flotation and that a public issue of securities appeared feasible. 
Consequently, he had prepared a memorandum which presented in out- 
line three programs for raising the funds for the purchase. The programs 
were based on the assumption that Cambridge Metal could secure an 
option to buy 12,255 shares of Precision Forgings stock before it entered 
into any program of security issue. After discussion with the company's 
lawyers, Mr. Prescott also assumed that, if the purchase of stock were 
consummated, the two companies would be merged as soon as possible 
and the Precision Forgings stock retired. The lawyers advised that a 
statutory merger of the type Mr. Prescott contemplated was possible 
under the laws of Massachusetts, in which state each of the companies 
was incorporated. Such a merger, however, required the approval of 
two-thirds of the stockholders of each company. It was believed that 
there would be little or no difi&culty in gaining the necessary approval of 
Cambridge Metal stockholders; and, since Cambridge Metal would own 
95% of the Precision Forgings stock, approval on the part of Precision 
Forgings was assured. Under the laws of Massachusetts dissenting stock- 
holders of either company who voted against the merger were entitled 
to receive payment in cash for the value of their stock on the day of the 
merger. In the event the corporation and a dissenting stockholder were 
unable to agree on the value to be placed on the stock, such value was to 
be ascertained by three disinterested persons, one of whom was to be 
designated by the stockholder, one by the corporation, and the third by 
the two thus chosen. Mr. Prescott believed that few Cambridge Metal 
stockholders would object to the merger and demand payment for their 
shares. 

In view of Mr. Putnam's concern about the size of the purchase, 
Mr. Prescott had reviewed the balance sheets of both companies with 
Mr. Breed. They agreed that the company after merger could operate 
with less cash than the combined cash accounts of the two companies 
on Sepetmber 30. They also questioned the need for continuance of the 
life insurance carried by Precision Forgings. After considerable study 
they decided to recommend that Cambridge Metal plan to convert its 
130,000 in government bonds into cash and then utilize $250,000 of 



Cambridge Metal Products, Inc. 343 

cash from the company treasury for the stock purchase. After the merger 
the company would, according to their recommendations, hquidate the 
$110,000 hfe insurance pohcy now carried by Precision Forgings. With 
the cash Precision Forgings now had, the cash on hand would then be 
adequate for the needs of the company after the merger. Thus, under 
these plans, for purchase of the entire 12,900 shares of Precision Forg- 
ings stock at $120 a share a total of $1,548,000 would be required and 
Cambridge Metal Products, Inc., should plan to raise approximately 
$1,300,000. 

The three plans for raising the $1,300,000 that Mr. Prescott felt 
most worthy of consideration were: 

1. Creation of a new issue of 5% cumulative, nonvoting preferred stock and 
sale of 13,000 shares to net $100 per share to the company. The stock would be 
callable at the option of the company at 105. 

2. Arrangement of a 4^% term loan for $1,300,000, with repayment to be 
scheduled in equal installments over a 10-year period. 

3. Sale of 130,000 shares of $1.00 par common stock at $10 per share net 
to the company.^ 

Exhibit 1 

CAMBRIDGE METAL PRODUCTS, INC. 

Summary of Earnings 

(Dollar figures in thousands) 

Cost Net Profit Net Profit 

Net Sales of Sales before Taxes after Taxes 

1933 $ 244 $ 237 $ 82** $ 82^^ 

1934 457 388 lO'' 10'^ 

1935 806 605 106 86 

1936 763 551 94 82 

1937 1,266 899 154 117 

1938 893 674 37 31 

1939 1,490 1,031 234 191 

1940 2,419 1,662 148 110 

1941 2,446 1,975 210 139 

1942 5,212 4,650 735 200 

1943 6,859 5,749 724 222 

1944* 7,100 5,900 750 240 

* Estimated. 
^ Loss. 

From his talks with the bankers Mr. Prescott was convinced that the 
prices and terms of the issues were reasonable under present market 
conditions. He also stated that each of the bankers had assured him that 
the new common stock could be widely distributed, with limits on the 
amount sold to any one individual. 

^ On November 25, 1944, the over-the-counter quotation (bid) for Cambridge Metal 
Products, Inc., stock was $11.50 per share. 



344 Case Problems in Finance 

Exhibit 2 

CAMBRIDGE METAL PRODUCTS, INC. 

Balance Sheet on September 30, 1944 

(Dollar figures in thousands) 

ASSETS 

Current assets: 

Cash $ 244 

U.S. government securities . 30 

Accounts receivable 293 

Inventory 321 

Total current assets $ 888 

Plant and equipment $ 445 

Less : Allowance for depreciation 181 

Balance $ 264 

Deferred charges 16 

Cash surrender value of life insurance 7 

Claims for refunds on federal taxes 127 

Miscellaneous .... 

Total assets $ 1,302 

LIABILITIES AND CAPITAL 

Current liabilities: 

Accounts payable $ 230 

Accrued liabilities 66 

Provision for federal income taxes 323 

Total current liabilities $ 619 

Capital: 

Common stock outstanding, $1.00 par value $ 95 

Earned surplus 588 

Total capital % 683 

Total liabilities and capital $1,302 



Exhibit 3 

PRECISION FORCINGS COMPANY 

Summary of Earnings 

(Dollar figures in thousands) 



Net Sales 

1935 $1,614 

1936 2,163 

1937 2,349 

1938 1,324 

1939 1,841 

1940 1,990 

1941 3,849 

1942 4,000 

1943 3,862 

1944* 4,200 

* Estimated. 





Net Profit 


Net Profit 


Cost of Sales 


before Taxes 


after Taxes 


$1,078 


$184 


$159 


1,349 


413 


356 


1,618 


333- 


271 


999 


40 


35 


1,360 


148 


120 


1,532 


120 


94 


2,717 


326 


220 


3,296 


274 


160 


3,130 


228 


94 


3,450 


392 


222 



Cambridge Metal Products, Inc. 345 

Exhibit 4 

PRECISION FORCINGS COMPANY 

Balance Sheet on September 30, 1944 

(Dollar figures in thousands) 

ASSETS 

Current assets: 

Cash $ 353 

U.S. government securities 150 

Accounts receivable 630 

Inventory 849 

Total current assets S 1,982 

Plant and equipment $1,945 

Less: Allowance for depreciation 786 

Balance $1,159 

Deferred charges 68 

Cash surrender value of life insurance Ill 

Claims for refunds of federal taxes 86 

Total assets $3,406 



LIABILITIES AND CAPITAL 

Current liabilities: 

Accounts payable $ 76 

Accrued liabilities 95 

Provision for federal income taxes 214 

Total current liabilities $ 385 

Reserves : 

For pensions 73 

Postwar contingencies 640 

Total liabilities $1,098 

Capital : 

Common stock, $100 par $1,290 

Earned surplus 1,018 

Total capital $2,308 

Total liabilities and capital $3,406 



PART 5 
COMPREHENSIVE PROBLEMS 



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Mitchel's Store, Inc. 



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In October, 1947, Mr. Paul Clark, a vice-president of the Standard 
National Bank in a city in New York State, asked James Leskie, a mem- 
ber of the credit department, to analyze the present financial condition 
of Mitchel's Store and the trends in its condition as shown by the figures 
presented in Exhibits 1 through 5. Mr. Leskie accumulated the data 
shown in Exhibits 6 to 9, from material in the bank's library, because it 
might aid him in studying the operations of Mitchel's Store. 

Mitchel's Store currently had an annual sales volume of about 
$1,250,000 and was located in a large city west of Albany. Originally, 
Mitchel's limited its line to home furnishings, which included furniture, 
draperies, rugs, lamps, records, radios, and pianos. The company had a 
long record of earnings. In spite of the sharp contraction of high-quality 
furniture sales during the depression of the 1930's, the company lost 
money for only two years. Through retention of earnings, the net worth 
had been steadily increased, although dividends had been paid regularly. 

The company, since its inception in 1925, had been operated by 
David Mitchel, who owned substantially all the capital stock. In 1946, 
he was 67 years of age. Since 1943, David Mitchel had depended on Mr. 
J. M. Rogers to a large extent for the management of the store. Mr. 
Rogers in 1946 was 47 years old, and for some years he had been treas- 
urer of Mitchel's Store. He was well thought of in trade and bank circles. 

In the early part of 1946, Mr. Mitchel and Mr. Rogers discussed 
with Mr. Clark of the Standard National Bank some plans they had de- 
veloped. Recently there had been a fire that destroyed an oflEice building 
adjoining Mitchel's Store. This property was owned by the same inter- 
ests as had leased the store building to Mitchel's. These interests planned 
the construction of a one-story "taxpayer" building to serve until build- 

349 



350 Case Problems in Finance 

ing costs declined. Messrs. Mitchel and Rogers felt that it would be wise 
to lease this new building. They proposed to install there in the next 
several months a department which would sell toys and sporting goods. 
It was felt that, inasmuch as Mitchel's was located in a downtown gen- 
eral shopping area, an expansion of this type would be profitable in it- 
self and would bring increased sales of furniture through combined 
patronage. Mr. Mitchel said that an oral agreement had been reached 
with the owners to reimburse the costs, amounting to about $35,000, 
which would be spent by the store to equip the new area and to provide 
connections with the older store. 

Mr. Mitchel and Mr, Rogers estimated that about $275,000 might 
be absorbed by the program. Part of this sum would go into increased 
quantities of the older lines of merchandise, about $70,000 into the new 
lines, and the balance into the equipment. Most of the latter expendi- 
ture was expected to be reimbursed by the landlord when the new build- 
ing was completed. It was proposed that the store would use its own 
funds to get the program under way, with the bank's advancing funds 
as needed up to $175,000. 

Mr. Clark recommended such a credit to the loan committee of the 
bank before the appearance of the March, 1946, balance sheet of Mitch- 
el's Store and the accompanying earnings statement. Mr. Rogers had re- 
ported that earnings were good and that the company's general position 
had not changed greatly since the previous March. The loan committee 
approved Mr. Clark's recommendation. 

In July, 1946, Mitchel's Store found it necessary to borrow from the 
bank. Mr. Rogers told Mr. Clark that the program of expansion was 
coming along well and that his budgets showed that the maximum of 
$175,000 for the loan was still a correct estimate. The new store would, 
he said, be ready for business at the start of the Christmas season. 

The initial loan for $55,000 was made July 15, 1946. The whole 
amount of $175,000 was outstanding by December L 

During the first week of December, Mr. Mitchel saw Mr. Clark. He 
said that an additional $45,000 loan would be needed. The new store 
equipment would cost about $75,000, or twice the estimate; the land- 
lord had denied making any agreement to reimburse part of this ex- 
penditure; construction would continue into January; and furniture 
manufacturers were making much larger shipments than had been 
hoped for. However, sales for the year ended November 1 were at the 



Mitchel's Store, Inc. 351 

record level of $1,500,000 and earnings were satisfactory. Mr. Mitchel 
said that the current budget showed that inventories would be reduced 
by March 31, 1947, so that the outstanding loan at that time would not 
exceed $85,000. 

Unfortunately, the new store building did not get into operation 
soon enough to take advantage of the Christmas buying season and it 
was necessary to have one-half price sales of toys and seasonal sport 
items nearly as soon as the opening. Markdowns of $5,500 were taken 
on a retail inventory valuation of $85,000 during the first three months 
of operation, and further markdowns of $4,250 were taken during April 
and May. Although the sales of furniture in the Christmas season were 
up to expectations, a policy of drastic order cancellations was instituted 
early in 1947, as manufacturers continued heavy deliveries. 

By the end of February, 1947, the expansion program had been ar- 
rested completely and each departmental manager was put on a strict 
inventory budget, instead of being entirely free of any controls as here- 
tofore. Both Mitchel and Rogers thought this control would bring reduc- 
tion of the inventory to $275,000 by July 31, 1947. Yet by March 31, 
1947, the Standard National Bank had outstanding loans of $265,000 
to Mitchel's Store, for, although the program to curtail inventories was 
inaugurated in earnest in February, it did not show very much effect 
until May. Furthermore, the furniture department ran into difficulties 
with its inventory curtailment program because at least 40% of its items 
were on a quota basis with the manufacturers. The store would lose con- 
tact with these suppliers if they did not order their minimum quota, and 
some cancellations had to be reinstated. 

During the summer, Mitchel's Store paid $65,000 on its loan. In the 
early part of September, Mr. Mitchel came to see Mr. Clark, and said 
that August sales were about $150,000. However, because of a trucking 
strike, a week of deliveries had been lost and hence the book figures 
would only show sales of $97,000. He expressed confidence that the 
inventory situation was at last under control and proposed that the loan 
be repaid as follows: September, $30,000; October, $15,000; Novem- 
ber, $15,000; December, $15,000; January, $30,000; February, 
$30,000; and March, $30,000; leaving a balance of $35,000 to be re- 
paid in the next fiscal year. Mr. Mitchel also discussed with Mr. Clark an 
arrangement he had made with a finance company to purchase all new 
time sales accounts, with the store's agreeing to repurchase all those that 



352 



Case Problems in Finance 



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356 Case Problems in Finance 

Exhibit 4 

MITCHEL'S STORE, INC 

Monthly Profit and Loss Statements 

(Dollar figures in thousands) 

April May June July 

1947 1947 1947 1947 

Net sales |105 $126 $97 $95 

Less: Cost of sales 62 76 65 60 

Gross profit $43 $ 50 $ 32 $ 35 

Less: Operating expenses: 

Direct 44 41 15 16 

General 32 32 

$ 44 $ 41 I 47 $ 48 

Operating profit 1'' 9 15" 13'' 

Add: Other incomes: 

Miscellaneous ... 1 1 

Rentals 1 2 1 1 

Purchase discounts ... 1 1 

$1 $2 $3 $3 

Net profit for month .$0 $ 11 $ 12'' $ 10' ' 

1946 1946 1946 1946 

Net sales $99 $124 $131 $103 

Less: Cost of sales _58 73 77 62 

Gross profit $41 $ 51 $ 54 $ 41 

d Deficit. 



Aug. 
1947 


Sept. 
1947 


$ 97 
67 

$ 30 


$137 

81 

$ 56 


15 
31 


18 
30 


$ 46 
16" 


$ 48 
8 


1 
1 
1 

$ 3 
$ 13" 


1 

4 

1 
$ 6 
$ 14 


1946 


1946 


$109 
65 

$ 44 


$134 

79 

$ 55 



Exhibit 5 






MITCHEL'S STORE, INC. 






Accounts Receivables Aging 






(Dollar figures in thousands) 
Mar. 31 
1942 


Mar. 31 
1947 


Sept. 30 
1947 


Regular Accounts: 

Three months old or less $48 

Three to five months old 7 

Over five months old 9 


$146 

21 

13 

1 

$181 


$143 
22 
17 


In hands of attorney 

$64 


7 
$189 


Installment Accounts: 






Accounts not in arrears $36 

Accounts in arrears: 

Portion due after statement date 13 

Portion due prior statement date 10 

Accounts in hands of attorney 

$59 


$ 37 

7 

7 

1 

$ 52 


$ 48 

4 

7 
2 

$ 61 


Reserve for bad debts $ 7 


$ 11 


$ 14 



Mitchel's Store, Inc. 357 

defaulted on their first three payments. This, it was felt, should even- 
tually release $25,000 to $40,000 formerly needed to finance such re- 
ceivables. If this were done, payments to the Standard National Bank 
could be accelerated. 

On October 1, Mr. Mitchel called Mr. Clark to say that arrange- 
ments with the finance company had progressed so satisfactorily that it 
would be possible to discount at least $35,000 of the existing install- 
ment receivables. Thus the store planned to pay the bank $45,000 
within the next few days. 



358 



Case Problems in Finance 






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Exhibit 7 
MITCHEL'S STORE, INC. 

Excerpt from "Retail Sales Trends, 1935-1944," Prepared by Dun & Bradstreet, Inc., 

for NRDGA, Published November, 1946, Report for , Netc York 

Unweighted Indexes of Sales 
(Average Annual Sales 1936-1939 = 100) 

All Stores Department Furniture 

Reporting Stores Stores 

Year (24 stores*') (4 stores') (6 stores) 

1935 84.8 82.8 87.4 

1936 94.2 93.2 98.4 

1937 100.6 99.9 104.4 

1938 98.2 98.6 92.4 

1939 107.0 108.3 104.8 

1940 112.7 114.5 115.7 

1941 134.3 137.1 151.7 

1942 139.0 142.7 163.1 

1943 141.7 147.0 151.9 

1944 155.3 164.2 144.1 

* Includes one "gift shop," one "dry goods" store, and one music store. 



Exhibit 8 

MITCHEL'S STORE, INC. 

Furniture Store Ratios Published by Dun & Bradstreet, Inc.* 

Based on Fiscal Year-End Figures for 1946-1947 

Upper Lower 

Unit Quartile'\ Median^ Quartilef 

Current assets to current debt Times 16.24 4.84 2.72 

Net profits to net sales % 13.54 7.29 3.25 

Net profits to tangible net worth % 32.85 19.94 10.84 

Net profits to net working capital % 48.03 25.11 10.05 

Turnover of tangible net worth Times 3.67 2.52 1.67 

Turnover of net working capital Times 6.76 3.64 2.66 

Net sales to inventory Times 10.8 5.9 4.5 

Fixed assets to tangible net worth % 1.5 5.2 15.2 

Current debt to tangible net worth % 6.9 16.3 40.3 

Inventory to net working capital % 32.3 50.8 73.4 

Current debt to inventory % 34.6 74.4 100.9 

* These appear in Dun^s Review, October, 1947. Used here by permission of Dun & Bradstreet, Inc. 

t To obtain these figures, the ratios for the stores were arranged in order of size. The median ratio is the one at 
the middle of this series. The quartiles are the ratios that were halfway between the extremes and the median (or 
one quarter of the way from each extreme). In each case the figure used is reached by counting the items, not by 
averaging the ratios. 

Exhibit 9 

MITCHEL'S STORE, INC. 

Indexes of Department Store Sales and Stocks 

(1935-1939 Average = 100) 

Prepared by the Federal Reserve Bank of New York 

Sales Stocks 

April 223 233 

May 237 224 

June 231 206 

July 170 193 

August 179 215 



I 



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Jollum Grocery Corporation 



IX\VVVVVVVVVVVAAA/VVV\V\\VVV\VVVV\VVVVVV\VVVVVVVA/IVV\VVVVV^^ 



In November, 1946, Francis Connolly, the head of a firm of business 
consultants in St. Louis, was introduced to Mr. Richard Parrish, the gen- 
eral manager of the Jollum Grocery Corporation. Mr. Parrish asked if 
Mr. Connolly's firm would work with the executives of the corporation 
in the next few weeks to review the company's problems, especially 
questions of policy in obtaining funds. During recent months it had been 
necessary for the company to make large payments for the purchase of 
real estate. These payments, combined with the need to finance continu- 
ing expansion, had caused the management to have some doubts about 
its ability to handle the usual expansion of inventory in the winter of 
1946-1947. 

Mr. Connolly indicated that his firm would like to undertake the 
work, and an appointment for conferences in the offices of the Jollum 
corporation was made for the following week. During the interval Mr. 
Connolly and an assistant made a preliminary investigation of the Jol- 
lum Grocery Corporation. They found that it was generally considered 
to be a highly successful enterprise, chiefly because of its spectacular 
growth. The predecessor enterprise had been founded as a proprietorship 
by Mr. Fred Jollum in 1928 to act as a food brokerage firm, and from 
that year until early in 1936 it had operated in St. Louis as a broker for 
about a dozen large retail grocery stores. These stores had been per- 
suaded by Mr. Jollum to pool their buying power for the purchase of 
many staple grocery products. 

During 1935 Mr. Jollum met Mr. Parrish, who was at that time the 
district manager in Chicago for a large chain-store company. Mr. Par- 
rish proposed the idea of going into a wholesaling business by expand- 
ing the Jollum company into a corporation. He proposed a voluntary 
chain in areas south of St. Louis where chain-store activity had as yet 
been small. Mr. Parrish felt that there was a great opportunity for the 

361 



362 



Case Problems in Finance 



development of mutual relationships between wholesalers and retailers 
that would preserve some of the values of independent operation and 
yet permit efficient distribution. Since Mr. Jollum had also been think- 
ing along the same lines, an agreement was shortly reached and the 
Jollum corporation was formed. 

The initial capitalization was made up of stock issued to Mr. Jollum 
for the net worth of his proprietorship and an equivalent amount of 
stock issued to Mr. Parrish for cash. Since the intent was to form a vol- 
untary chain, the bylaws of the corporation provided that no stock could 
be transferred unless it was first offered to the corporation. It was ex- 
pected that, as additional capital stock was needed, it could be sold to the 
stores served by the corporation. 

The idea that a voluntary chain in the region would be successful 
proved to be true. Sales increased very rapidly and profits also, as indi- 
cated in the following table: 



Year 


Sales 
(In Thousands) 


Net Profit 
before In- 
come Tax 
(In Thousands) 


Year 


Sales 
(In Thousands) 


Net Profit 
before In- 
come Tax 
(In Thousands) 


1936 

1937 

1938 

1939 

1940 


$ 228 

427 

574 

857 

1,248 


$ Id 
1 

7 
12 
16 


1941 

1942 

1943 

1944 

1945 


$1,686 
2,212 
2,568 
3,273 
3,725 


$33 
49 
19d 

10 
45 



d Deficit. 



In carrying out his part of the preliminary study, Mr. Connolly's 
assistant made a brief review of the last published balance sheet of the 
corporation for December 31, 1945. It showed reasonable relationships 
for a grocery wholesaling company. At that time the corporation had 
slightly more debt than was common among such corporations, about 
$100,000 of which was found to be due to the estate of Mr. Jollum. He 
had died in 1943, and the trust company that had been named his 
executor had requested that his stock be repurchased by the corporation. 
It had, however, accepted 5 % demand notes in payment for the shares. 

Information with respect to operations in 1946 was somewhat 
scanty, as the corporation did not publish interim statements. Mr. Con- 
nolly did learn that the corporation had bought a warehouse and land in 
Tulsa, where it had formerly been warehousing in rented property, and 
that in Memphis it had bought some vacant land along the river while 



JoLLUM Grocery Company 363 

continuing to operate in a rented warehouse. It had owned its principal 
office and warehouse in St. Louis since 1942. 

The financial service consulted by Mr. Connolly's assistant described 
the nature of the business as follows: 

The corporation handles about 1,400 ordinary grocery items covering every 
class of goods handled by the ordinary grocery store, including frozen foods and 
produce. Meat is not distributed, although most of the stores served sell it. About 
800 of the 1,400 items sold bear a private brand copyrighted by the corporation. 

The merchandise is purchased either from producers directly or through bro- 
kers in large lots. Some of the merchandise, notably coffee, is processed and re- 
packed by the corporation for resale. Merchandise is distributed out of inventory 
on weekly orders and is not contracted for by the retail stores in advance. The 
number of retail customers is approximately 250, but we understand that about 
50 stores make up about half of the dollar volume of sales. 

When the conference at Mr. Parrish's office opened, Mr. Connolly 
found that a balance sheet as of September 28, 1946, the most recent 
date at which inventory had been taken, had been made available for his 
use. Mr. Parrish had included the balance sheet of the preceding Septem- 
ber, since he felt that the seasonality of the business was such that a com- 
parison with the year-end figures would not be as informative. These 
balance sheets appear in Exhibit 1, together with notes which Mr. Con- 
nolly made shortly after the conference. 

At Mr. Connolly's suggestion, Mr. Parrish arranged for the prepara- 
tion of a condensed comparative income statement of the corporation 
for the nine months ending September 28, 1946, and the preceding 
three fiscal years. These figures appear in Exhibit 2, together with Mr. 
Connolly's notes. 

In describing the events of 1946 that led to the condition in Sep- 
tember, Mr. Parrish said that the increase in sales volumes had been ex- 
pected. The growth in physical volume shipped continued previous 
trends, and in addition there were further increases in the dollar figures 
of sales because of price rises. The unexpected reductions of working 
capital were caused by the purchase of real estate in Tulsa and Memphis. 
In each of these cities the corporation had been operating a branch ware- 
house on leased property. In both cases the leases had expired in 1946 
and renewals were not possible. A satisfactory warehouse had been 
purchased in Tulsa, but in Memphis an unsatisfactory substitute had to 
be rented. At the same time a large parcel of real estate on the river was 
bought as a site for a warehouse. The company believed that a ware- 



364 Case Problems in Finance 

house adequate for present volumes could be built there in 1947 for 
about $80,000. 

Both the St. Louis and Tulsa warehouses were larger than was neces- 
sary for current volumes of shipments. Fortunately, it had been possible 
to rent the unused space at satisfactory rentals. Mr. Parrish said that he 
estimated that these warehouses would not be operated at full efficiency 
until the sales volume of the company had reached approximately 
$8,000,000 a year. In the meantime, unneeded space would be rented. 

The purchase of the property in Tulsa had been accomplished with 
the assistance of a $72,000 purchase money mortgage. By Sepetmber 28 
the corporation had successfully negotiated for an increase of this mort- 
gage to $80,000. The insurance company which held the obligation had 
agreed to make this new loan at 4% on 20-year terms. During the nego- 
tiation it had indicated an interest in lending on the property in St. Louis 
and in making a loan at Memphis whenever a building was completed 
there. 

Mr. Parrish said that the sale of stock had been an important source 
of new funds in 1946. Late in 1945 the corporation had authorized the 
issuance of $300,000 par value of 4% cumulative preferred stock as 
well as the sale of additional shares of common stock as buyers might be 
found. In each case the stock was to be offered only to stores affiliated 
with the Jollum corporation or their owners. The application of the 
proceeds of the sales of stock to real estate had changed the original plan 
to use the money solely for the reduction of the long-term debt of the 
corporation. 

With respect to the debts, Mr. Parrish told Mr. Connolly that the 
debenture bonds had been adopted as a device for raising money some 
years previously. The bonds bore interest at 3 % and matured five years 
after the date of issue. Sales had been made only to co-operating retail 
stores or to the owners of these stores. Experience indicated that at matu- 
rity many of the bondholders consented to the issuance of new bonds of 
similar tenor in place of cash payment. In 1946 a number of the bond- 
holders, on request, had been willing to exchange their 3% bonds for 
4% preferred stock. Some had volunteered to do this before the matu- 
rity of the bonds. 

The demand notes payable to the Jollum estate drew interest at 5 %. 
They were held by a trust company which was the executor. This com- 
pany had indicated that it desired to have these notes paid as soon as 
could be done without embarrassing the corporation, and some small 



JOLLUM Grocery Company 365 

reductions had been made. Mr. Parrish felt that there would be no pres- 
sure for immediate reduction but no additional funds could be obtained 
from this source. 

It was the long-run objective of the corporation to pay off long-term 
debts by the expansion of its capital and the reinvestment of earnings, 
but Mr. Parrish felt that little additional money could be obtained from 
the sale of stock in the next few months. 

In response to a question put by Mr. Connolly, Mr. Parrish said that 
the company banked with the Farmers Deposit Bank, a small bank in 
St. Louis. Legal limitations made it impossible for this bank to extend 
unsecured loans in excess of $28,000, and the bank's policy was that it 
would not loan more than $100,000 to any customer on any basis. It 
was charging 2j% on the $91,000 currently outstanding on a loan par- 
tially secured by certain inventory items. The bank's president had re- 
cently agreed with Mr. Parrish that even more funds might be needed in 
the next few months. He had offered to arrange an introduction to one 
of the large St. Louis banks in case the company should decide to request 
credit from such a source. It was the thought of the bank's officers that 
such a loan, also on a secured basis, would be arranged so that their 
bank might participate in it. 

Grocery wholesalers generally have peak inventories during the 
winter and spring. They are reduced in the summer as the time ap- 
proaches to buy a new season's "pack." There is considerable variation 
in weekly sales, due to holidays, but no great variation in sales due to 
other seasons. 

Mr. Connolly discussed the JoUum corporation's inventory position 
with the chief buyer of the organization. He learned that the market was 
still tight but that deliveries received in August indicated some easing of 
the seller's market. The buyer indicated that he was buying to meet a 
sales level of 120% of the 1946 dollar volume, although he was ''a lit- 
tle ahead" of himself at the end of September. The peak investment in 
inventory was usually in June or July, and the buyer said he would like 
to be able to go as much as $150,000 over present levels, in order to be 
relieved of financial worries if buying opportunities arose. 

Mr. Connolly inquired about the prospect of price declines in 1947 
and was told that if turnover continued as high as it had been recently 
the company could absorb up to a 10% decrease in wholesale prices 
without going into the red at all. This opinion was based on the assump- 
tion that prices would fall off gradually enough to permit the adjustment 



366 



Case Problems in Finance 



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JoLLUM Grocery Company 



367 



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368 



Case Problems in Finance 



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JoLLUM Grocery Company 369 

of all prices from producer to consumer on a fairly even basis. A sudden 
drop in prices would cause considerable loss. 

The buyer also told Mr. Connolly that there had been no great 
changes in the volume of inventory since the physical count had been 
taken in September but that fairly large shipments would normally be 
received in the next few weeks. Mr. Parrish said that he thought the 
company could "find the money" to take care of such increases for a 
month or so without borrowing funds, but it might mean abandoning 
the advantages of taking discounts. 

As the conference closed Mr. Parrish asked Mr. Connolly to write 
him a preliminary report which would review the possible sources of 
funds available to the company and give some tentative recommenda- 
tions for discussion. Mr. Connolly replied that he would be glad to sub- 
mit such recommendations. The report, he said, would include, among 
other things, discussion of the alternative types of loans available as well 
as the types of institutions that might be interested in the negotiation of 
actual loans. Perhaps, too, he might be able to suggest changes in com- 
pany policy that would relieve the need for funds. 



IVVVVWVV\VV\VV\\VWWVVVVMAVVVWVV\A\VVVIA^\VVVVVVVV\AA^^ 



Eagle Packing Company, Inc. 



IVVVVVVVVVVVVVVVVVVV\VWVVVV\VVVVVVVVVVWVVVVVVVVVVWVA\VVVWV^^ 

The Eagle Packing Company, Inc., was organized in 1923 by Mr. 
Fred Farley and a few associates in a city in Pennsylvania. At first the 
company specialized in manufacturing quality pork products, such as 
sausages and hams. Over the years it broadened its lines by adding beef 
products. Sales were centered in eastern Pennsylvania, New Jersey, and 
"upstate" New York. During 25 years of operations the company had 
never suffered an annual loss on its operations, although its earnings had 
fluctuated widely. 

In 1934, Mr. Farley felt that further expansion should prove profit- 
able, but neither he nor the company had sufficient resources to carry 
out these plans. Without the assistance of any investment or commercial 
bankers, Mr. Farley had been able to sell at par 26,746 shares of 7% 
nonvoting cumulative preferred stock, $100 par, callable at 107, along 
with some 54,000 common shares. These shares were sold largely 
through the efforts of Mr. Farley and his sales force to personal friends 
and business acquaintances. After this sale the capitalization of the com- 
pany consisted of $2,674,600 of 7%, $100 par, preferred shares and 
$2,575,965 in common shares, $15 par. 

In the late summer of 1945 the company purchased a beef slaugh- 
tering plant at Des Moines, Iowa, which it had been leasing since 1 942 
at an annual rental cost of $62,500. The plant was acquired in exchange 
for 1,625 shares of 7% preferred stock and 18,375 shares of common 
stock. In arriving at a sale price, the preferred stock was valued at par 
and the common stock at $22 per share (its approximate book value) 
for an aggregate value of $566,750. 

Immediately after the purchase of the Des Moines plant, a program 
of expansion to provide additional branch facilities was inaugurated. In 
order to secure the $1,250,000 needed for this program as well as 
$1,250,000 required for additional working capital, $2,500,000 was 

370 



Eagle Packing Company 371 

borrowed from the Eastern Mutual Life Insurance Company by means 
of a 3i% first mortgage bond issue, with a repayment provision de- 
signed to retire the whole issue over 1 5 years. 

The mortgage indenture provided for fixed semiannual payments on 
January 31 and July 31 of $107,824, including both interest and prin- 
cipal. These bonds were callable at 103 for nine years, declining ^% 
each year thereafter, being 1 00 during the fifteenth year. The indenture 
also stipulated that dividend payments could be made only from surplus 
earned subsequent to November 1, 1944, and then only if, after giving 
effect to the payment of any dividends, working capital were at least 
$3,000,000 and the current ratio 1.5. 

In August, 1946, in order to provide working capital, 12,000 shares 
of common stock were offered at $25 to common stockholders. Mr. 
Farley did not exercise his stock purchase rights in order to allow mem- 
bers of the management to buy the unsubscribed shares. This financing 
netted the company $300,000 in new money. The company at this time 
would have preferred to raise more money for working capital but did 
not wish to go to the bother and expense of SEC registration. See Table 
1 for a summary of securities issued from 1934 to 1947. Balance sheet 
data for 1945 and 1946 are given in Exhibit 1 (p. 375). 

Table 1 

EAGLE PACKING COMPANY, INC. 

Summary of Securities Issued 1934-1947 





Common 
Shares Par Value 


Preferred 
Shares Par Value 


Bonds 
Par Value 


Total outstanding 
as of 11/1/34 . 


. .171,731 


$2,575,965 


26,746 


$2,674,600 




Des Moines pur- 
chase (1945) . 


. . 18,375 


275,625 


1,625 


162,500 




Eastern Mutual 
(July, 1945) .. 










$2,500,000 


August, 1946 . . . 


. . 12,000 
..202,106 


180,000 
$3,031,590 








Bonds retired by 

11/1/46 
Total outstanding 

as of 11/1/46 . 


28,371 


$2,837,100 


$ 129,269 
$2,370,731 



As of July, 1947, Mr. Farley held about 40% of the outstanding 
common shares, the remainder being distributed among 1,400 holders. 
A fairly active over-the-counter market existed for these shares. Together 
with the officers, Mr. Farley controlled over 60% of the votes. Although 



372 Case Problems in Finance 

the preferred stock was held by an almost equal number of holders, an 
active market had not developed in these shares; and the current holders 
were largely those who had purchased the shares upon original issue. 
Exhibit 2 presents a record of quotations for the common stock. 

As shown in Exhibit 3, dividends on the preferred stock had been 
paid currently except in 1938. The rate of common stock dividends had 
been established at $1.00 per share in 1943 and was raised to $2.00 per 
year at the beginning of 1947. 

The Eagle Packing Company enjoyed cordial relations with three 
banks from which it borrowed heavily to finance seasonal operations. 
Reflecting record sales and resultant increased working capital needs, 
bank borrowings as of July, 1947, had reached an all-time high of 
$5,000,000, which the banks seemed glad to advance. These loans were 
unsecured and carried a 2^% interest rate. In the past the company had 
always been able to pay off the loans by November 1, the end of its fis- 
cal year; and it was expected that this would be possible in 1947.^ 

In June, 1947, the board of directors approved a $1,250,000 pro- 
gram of expansion to provide beef cooler facilities, additional smoked 
meat capacity, and the necessary working capital expansion. The facil- 
ities were expected to pay for themselves in a short time by lowering of 
costs and improved service to customers. Mr. Fred Farley was undecided 
as to the means of financing to be employed. In view of improved secu- 
rity markets, he also wondered whether the financial plan should include 
any refinancing of the current outstanding issues. Mr. Saxon, the treas- 
urer of the company, was instructed to investigate the possibilities. 

Mr. Saxon found that the Eastern Mutual Life Insurance Company 
would be willing to make a new 3^% loan for $3,750,000, which 
would, in effect, retire the current bond issue and provide $1,445,910 in 

^ The following quotation is from J. G. Glover and W. B. Cornell, The Development 
of American Industries (New York: Prentice Hall, 1941), p. 81. Quoted with the permis- 
sion of the publishers. 

"In spite of the fact that a great many meats and meat products are sold within a 
few days after the purchase of the livestock from which they are produced, merchandise 
inventories frequently represent the largest class of assets owned by packing companies. 
Total current assets — including inventories, accounts receivable and cash — will normally 
make up from 50-60% of the total assets of a meat packing company. 

"One other factor influencing the financial policy of meat packing companies is the 
seasonal accumulation of meat, which takes place during the winter months, when receipts 
of livestock are heavy. Total of stocks of products stored by the industry are usually from 
40 to 100% greater on the first of May than on the first of November. This accumulation 
of products requires substantial short-term financing by the packing companies. Borrowings 
are liquidated from the proceeds of sales as stocks are worked down during the summer 
months." 



Eagle Packing Company 373 

new money (as of July 31, 1947 ) . The general terms of the loan would 
be the same as those of the current loan, but the semiannual payments 
covering principal and interest would increase from $107,824 to 
$161,737 and the final payment would be in 1962. However, an "after 
acquired property" clause would be included in the indenture.^ The in- 
surance company would furthermore be willing to waive the redemp- 
tion premium on the current issue provided it were replaced by the 
larger issue. 

Mr. Saxon realized that such an increase in the funded debt, added 
to the short-term bank debt likely to be outstanding, would bring the 
total debt to about $10,500,000 at the seasonal peak next year if sales 
continued their present uptrend. He was not certain, however, whether 
such heavy use of borrowed money represented shrewd use of "leverage" 
or unconservative finance. 

After talking to the insurance company representative, Mr. Saxon 
arranged interviews at several investment banking firms. None of the 
bankers was willing to consider the purchase of a straight preferred is- 
sue. In their view, individual investors currently were interested in but 
two types of securities — very low risk bonds and highly speculative 
"double your money" issues. Individual investors were cool toward secu- 
rities that fell in between the two extremes. 

One firm that Mr. Saxon contacted. Gold and August, made a firm 
offer, subjea to market conditions remaining stable, to purchase up to 
175,000 shares, 5% cumulative preferred stock, $25 par, convertible 
into common Ij points above the market price of the common on 
the date of issue and callable at $27.50. (In his calculations, Mr. Saxon 
assumed that the market for the common would be $36, in which case 
three preferred shares would be convertible into two common shares. ) 
The issue would be sold to the public at par, with net proceeds to the 
company of 90%, or $22.50 per share. The offer, however, was condi- 
tioned upon the retirement of the 7 % preferred stock and no change in 
the present bond contract. 

Mr. Saxon realized that the majority of the people buying such a 
preferred issue would be doing so with the expectation that still higher 
earnings were in prospect for the company and that it would therefore 
be profitable for them to convert the preferred into common in a short 

^ "As security for an issue of bonds, a corporation often mortgages not only propert)' 
which it owns ... at the date of the mortgage deed, but it also covenants to extend the 
lien to property acquired in the future." — J. I. Bogen, Financial Handbook (New York: 
Ronald Press Co., 1949), p. 491. Quoted with the permission of the publishers. 



374 Case Problems in Finance 

period of time. In discussing the likelihood of conversion, Mr. Saxon 
learned that conversion seldom took place in large volumes at the option 
of stockholders, even when there was a profit to be taken. However, the 
representative of Gold and August stated that the Eagle Packing Com- 
pany could force conversion by calling the preferred when the conver- 
sion would be profitable. 

These same bankers made another oifer, also subject to market con- 
ditions remaining stable, to purchase up to 115,000 common shares at 
$32 net to the company. The issue would be sold to the public at $35 or 
$36. The recent sale by an estate of several thousand shares at $40 per 
share supported the view that 115,000 shares could be sold at $36. A 
condition of this offer, however, was the retirement of the balance of the 
mortgage loan of the Eastern Mutual Life Insurance Company. 

As he began his consideration of these alternatives, Mr. Saxon at- 
tempted to clarify the earnings aspect of the three possibilities by chart- 
ing their effect upon the earnings per share of common stock in 1948.^ 
This chart, he knew, illustrated only one aspect of a complex problem 
and is presented as Chart 1 (p. 377). 

(Note: An economic background of the meat packing industry as a whole 
is given in Appendix A of this case [p. 378}.) 

^ In this year, the interest on the existing bonds would be $77,078. If the new bonds 
were used, interest would become $129,568. 






Eagle Packing Company 375 

Exhibit 1 

EAGLE PACKING CO., INC. 

Balance Sheets 

ASSETS r November 1, 1945 n r November 1, 1946 n 

Cash $1,231,639 $1,215,255 

Government bonds 103,864 

Accounts receivable — net ... 2,091,951 2,472,773 

Inventories* 3,050,766 4,194,794 

Cash value— life ins 239,745 $6,717,965 264,862 $8,147,684 

Investments 25,380 74,875 

Property and plant $7,365,790 $8,243,522 

Less: Depreciation res 3,088,977 4,276,813 3,300,391 4,943,131 

Prepaid expense 357,164 385,357 

$11,377,322 $13,551,047 

LIABILITIES 

Accounts payable $1,037,088 $1,439,370 

Federal income tax 688,228 1,097,106 

Advances to customers 25,169 35,750 

1st mtg. bonds due 129,269 $ 1,879,754 133,843 $ 2,706,069 

1st mtg. bonds due to I960 . . 2,370,431 2,236,588 

Reserve for contingencies . . . 62,500 62,500 

7% preferred stock, $100 par: 

28,371 shares 2,837,100 2,837,100 

Common shares, $15 par: 

1945— 190,106 shares 2,851,590 3,031,590 

1946—202,106 shares 

Capital surplus 190,157 310,157 

Earned surplus 1,185,790 2,367,043 

$11,377,322 $13,551,047 

• Valued at lower of cost or market. 



Exhibit 2 

EAGLE PACKING CO., INC. 

Common Stock Quotations 

As of Last Trading Day of Month 



, — 1944 — , , — 1943 — , , — 1946 — . . — 1947 — ^ 
Bid Asked Bid Asked Bid Asked Bid Asked 



January 14^ 

February 15i 

March 16 

April 16 

May 17 

June 19 

July 19 

August 18^ 

September 18^ 

October 18^ 

November 19 

December 18 



16 


18 


20 


19 


22 


25 


27 


17i 


18 


m 


19 


22 


28 


29 


18 


18 


m 


21 


23 


28 


30 


18 


16 


18 


22 


24 


28 


31 


19 


17 


18 


22 


24 


33 


35 


20 


17 


19 


21 


22 


35 


37 


20 


17 


19 


23 


24 


41 


45 


20 


17 


19 


24i 


26 


. , 




20 


19 


20 


25 


26 






20 


20 


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26 


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20 


20 


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26 


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20 


20i 


22i 


25 


27 


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376 



Case Problems in Finance 



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Eagle Packing Company 

Chart 1 



^11 




HUNDRED THOUSAND DOLLARS 
NET PROFIT BEFORE BOND INTEREST OR TAXES 



378 Case Problems in Finance 

APPENDIX A 
ECONOMIC BACKGROUND OF THE MEAT INDUSTRY 

The meat packing industry's operations can be roughly divided into 
three functions, purchasing of hvestock, converting the livestock into 
meat and by-products, and distribution and selling. For the five-year pe- 
riod, 1936-1940, 73.6% of the meat packers' sales dollar went to the 
purchase of livestock, 25.5 % to costs of production including taxes, and 
less than 1 % constituted profit. 

Looking at the meat supply situation which constitutes about three- 
fourths of the packers' costs, it is found that the packer has very little 
control over this phase of his operations because of the keen competition 
among packers for the available livestock. The price paid for livestock 
depends largely upon the supply situation. This factor is more fully dis- 
cussed as follows: 

". . . The amount [of livestock} produced on these farms depends 
largely upon the amount of feed and forage produced, and the relative 
price of these feeds, compared with the price of meat animals. A large 
supply of feed and forage usually means that the farmers make the deci- 
sion to grow more livestock; a small supply that they will grow 
less. ... 

"When livestock has been raised and fed to market weights, they 
must be marketed rather promptly. If kept beyond the proper market- 
ing time they make very inefficient use of additional quantities of 
feed. . . . 

"The short- time swings, as well as the seasonal and annual fluctua- 
tions in the number of livestock that farmers send to market, therefore 
have considerable effect on meat [livestock] prices, since they result in 
corresponding changes in the supply of meat. . . . The fact that meat 
packers have no control of supply therefore automatically results in a 
change in meat [livestock] prices when supplies change, unless offset 
by a corresponding change in the demand for meat."^ 

As v/ill be observed from the following chart, meat consumption is 
not subject to violent fluctuations, or in other words, physical volume 
of production is not characteristically cyclical. However, it is true that 
usually the total value of all meat consumed varies directly with the 
total disposable income. Therefore, if the physical volume of meat sup- 



^Meat Price Facts, by R. J. Eggert, Associate Direaor, Department of Marketing, 
American Meat Institute, Chicago, Illinois. 



Eagle Packing Company 



379 



ply should remain constant and payrolls should drop drastically, prices 
of meat have to drop correspondingly in order to move the supply into 
consumer channels. This is well illustrated in the following chart for 
the years 1929 to 1940. (During the 1940's, rationing and price con- 
trols have interfered with this process of adjustment. ) From this it can 
be realized that the prices received for the packers' products are on the 
whole outside the packers' control. 



MEAT CONSUMPTION, FACTORY PAYROLLS. MEAT PRICES 

INDEX NUMBERS 1929-1930 = 100 


110 
100 
90 
80 
70 
60 
50 
40 























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/ 
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1930 1932 1934 1936 1938 1940 



Source: American Meat Institute 



From the above discussion it can be seen that in effect the packer is 
buying in one market over which he has no control, and selling in an- 
other over which he has no control. If he were buying and selling the 
same meat simultaneously, no great problem would be presented. How- 
ever, actually there is a lag of from a few weeks to months, depending 
upon the product, between the time he buys the livestock and sells the 



380 



Case Problems in Finance 



derived products. Should the supply or demand condition change un- 
expectedly during this period, the packer is in the position of having 
inventory losses or gains — especially if he values his inventory on a 
first-in, first-out basis. This problem is very acute inasmuch as the packer 
has no method of hedging against such losses. Many meat packers now 
use the last-in, first-out inventory method or use inventory reserves to 
mitigate the influence of these gains or losses. 

A rule of thumb in the packing trade is that a packer should secure 
an average profit of over 2% of net sales. It can be seen that, when 
meat prices tend to be high, profits tend to be high; and when meat 
prices slump, profits tend to slump. The cyclical nature of the packing 
house profits can be seen in the following chart. 



EARNINGS OF MEAT PACKING COMPANIESJ929-1946 

4-20 MILLION DOLLARS NET WORTH 
p[|{ ([ H^ { Earnings in Percentage of Net Worth ) 



18.0 



12.0 



6.0 



0.0 



-6.0 



































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1930 1932 1934 1936 1938 1940 1942 1944 1946 



Source: Packers and Stockyards Division, U.S. Department of Agriculture 



VVVVV\VVVVV\VVVVVVV\^VWVVVVVVA^AVWVVA^\<VVVV»AAVVVVVV^^ 

The Dayton Power and Light 

Company 

Morgan Stanley & Co., Incorporated 

vvvvvvvvwv\\\vvvvvvvvvvvvvwvvvvvvvwwvvvvvwc\\vvvvvvvvvw 



Note. — The following material consists of excerpts, without footnotes, from 
a Securities and Exchange Commission decision with the same title (8 SEC 950, 
March 27, 1941) and from the opinions written by the Circuit Court of Appeals, 
Second Circuit, when the decision of the Securities and Exchange Commission 
was appealed [Morgan Stanley & Co., Incorporated v. Securities and Exchange 
Commission, 126 Fed. (2d) 325, February 20, 1942}. 



FINDINGS AND OPINION OF THE COMMISSION 

The questions before us are whether Morgan Stanley & Co., In- 
corporated, stood in such relation to The Dayton Power and Light Com- 
pany that there was liable to have been an absence of arm's length 
bargaining between them with respect to the issuance and sale to the 
public of $25,000,000 of first mortgage bonds of The Dayton Power 
and Light Company in February, 1940, . . . 

This proceeding was instituted pursuant to Rule U-12F-2 of the 
General Rules and Regulations under the Public Utility Holding Com- 
pany Act of 1935, by an order to show cause addressed to The Dayton 
Power and Light Company and Morgan Stanley & Co., Incorporated. 
The Dayton Power and Light Company is a public utility subsidiary of 
Columbia Gas and Electric Corporation which is in turn a subsidiary of 
The United Corporation.^ Both Columbia and United are registered 
holding companies. Morgan Stanley is an investment banker. Prior to 
our issuance of the order to show cause Dayton had applied to us pur- 
suant to Section 6 (b) to exempt the issue and sale to the public of 

■^ Rule U-12F-2, The Dayton Power and Light Company, Morgan Stanley & Co., In- 
corporated, Columbia Gas & Electric Corporation, and The United Corporation are here- 
inafter sometimes referred to respectively as the "rule," "Dayton," "Morgan Stanley," 
"Columbia," and "United." The Public Utility Holding Company Act of 1935 will be 
referred to as the "Aa." 

381 



382 Case Problems in Finance 

$25,000,000 of its mortgage bonds from the provisions of Section 6 
( a ) of the Act. The application disclosed that Morgan Stanley was one 
of the underwriters to whom Dayton proposed to sell the bonds and 
that Morgan Stanley's participation was to be more than 5 per cent. 

The questions raised in this proceeding are most intricate and dif- 
ficult. Our desire to be thoroughly familiar with the record facts and 
to probe the ramifications of the problems involved has occasioned long 
delay. 

THE RULE 

One of the more serious holding company problems arises out of 
the frequent existence of inter-relationships between holding company 
systems and their investment bankers that give rise to considerable doubt 
whether, in transactions between them, the subsidiary public utility 
companies in the system have had the advantages of arm's-length deal- 
ing. Congress indicated considerable concern about such relationships 
in various sections of the Act as well as in reports and debates which 
formed the basis for the Act. These we will discuss in some detail 
further along in our opinion. In the administration of the Act, one 
serious difficulty which we have encountered in our efforts to carry out 
the Congressional intent has involved the timing of issuance of securi- 
ties. Either because of a maturity date or a call date, or because of threats 
of market disruptions, we were under pressure to permit the financing 
to go through in the form and upon the terms proposed. 

On the basis of our experience in carrying out the provisions of the 
Act, we believed that the solution to the problem lay in establishing 
a mechanism which would sift out in advance the cases of special re- 
lationships and neutralize the effects of such relationships wherever 
found. Accordingly, on December 28, 1938 the Commission adopted 
Rule U-12F-2 to become effective March 1, 1939. When an investment 
banker stands in such relation to a public utility company that there 
is liable to be an absence of arm's-length bargaining between them in 
an underwriting transaction, the Rule forbids the payment of an under- 
writer's or manager's fee to such investment banker if its participation 
exceeds 5 per cent of the total offering; provided, that the prohibition 
of the rule is not applicable if diligent effort was made to obtain com- 
petitive bids for the securities, or if such effort is shown to have been 
impracticable and certain other conditions are satisfied. In the case be- 
fore us no effort was made to obtain competitive bids, nor has there 
been any showing that such effort was impracticable. 



Dayton Power and Light Company 383 

As the validity of the Rule cannot be determined except in the light 
of its applicability to the facts of this case, we shall proceed at once to 
a consideration of such facts. 

THE RELATIONSHIP 

The relationship, if any, between Dayton and Morgan Stanley arises 
out of certain intermediate relationships, namely: (1) the position of 
Dayton as a subsidiary of Columbia and the position of Columbia as a 
subsidiary of United; (2) the incentive attributable to leading partners 
of J. P. Morgan & Co. to secure underwriting business for Morgan 
Stanley; and ( 3 ) the influential position of J. P. Morgan & Co. in the 
affairs of United. In other words, the argument of counsel for the Public 
Utilities Division is that Dayton, through Columbia, is susceptible to 
domination by United; that leading partners of J. P. Morgan & Co. 
have a strong motive for securing business for Morgan Stanley; and 
that J. P. Morgan & Co. has occupied such an influential position with 
respect to United that it has been able to place Morgan Stanley in a 
preferred position with respect to the underwriting business of com- 
panies within United's sphere of influence, including Dayton. Through 
the links of this chain, counsel for the Public Utilities Division main- 
tain that Dayton and Morgan Stanley stood in such relationship to each 
other that there was liable to have been an absence of arm's-length 
bargaining in the underwriting transaction relating to the Dayton bond 
issue. 

We take up each of these propositions in the order stated. 

( 1 ) Dayton is a subsidiary of Columbia, and Columbia is a sub- 
sidiary of United. 

Under the Act, a company is automatically given the status of a 
subsidiary of a holding company if 10 per cent or more of its voting 
securities are owned, controlled, or held with power to vote, by such 
holding company. 

Dayton's voting securities have been 100 per cent owned by Co- 
lumbia since 1925; and since May, 1930, at least 19-6 per cent of 
Columbia's voting securities have been owned by United. Both Colum- 
bia and United are registered under the Act as holding companies. The 
consequences that attach to the status of subsidiary companies of reg- 
istered holding companies arise out of the statute itself, not out of any 
determination we may make. If such consequences are to be avoided, 
it is incumbent upon either the subsidiary company or the holding com- 
pany to apply to us for an order declaring such subsidiary company not 



384 Case Problems in Finance 

to be a subsidiary of the specified holding company. No such application 
has ever been filed with respect to Dayton; and although at one time 
Columbia filed an application for an order declaring it not to be a 
subsidiary of United, that application was withdrawn by Columbia be- 
fore it came to a hearing. 

By reason of the status of Dayton and Columbia as subsidiaries of 
United, therefore, it follows as a matter of course that a person in- 
fluential in the financial affairs of United would also stand in a similar 
relationship to United's subsidiaries, and is within the scope of the Rule. 
Of course, it is not necessary for the purpose of the Rule to find a parent- 
subsidiary status between Dayton and Columbia and United. The Rule 
also embraces more subtle relationships which may so link corporations 
and individuals that there is liable to be an absence of arm's-length 
bargaining in transactions between them. On the facts, as hereinafter 
set forth, we also find that such a relationship exists between Dayton and 
Columbia and United. 

(2) The incentive of leading partners of J. P. Morgan & Co. to 
secure business for Morgan Stanley. 

Morgan Stanley was formed as an investment banking house by 
partners of J. P. Morgan & Co. and its Philadelphia firm, Drexel & Co. 
These firms, forced by the Banking Act of 1933 to elect between com- 
mercial banking and investment banking, chose the former. They were 
therefore compelled to terminate their underwriting business as of 
June, 1934. 

At that time the securities markets were virtually dormant, and 
when they began to reopen in 1935 the members of the Morgan-Drexel 
firms entertained hopes that the Banking Act might be amended to 
permit commercial banks to underwrite and wholesale securities. About 
July of 1935, however, it became apparent that such an amendment 
would not be enacted, and the members of the Morgan-Drexel firms 
concluded that a separate organization should be formed to engage in 
investment banking. It was agreed among them that certain partners 
and employees should leave the firms and become directors, executive 
officers, and employees of the new organization. Some of the remaining 
partners of J. P. Morgan & Co. agreed to 'grub-stake" the new organi- 
zation by purchasing its preferred stock, and this they did according to 
their individual means and inclinations. 

On September 6, 1935, Morgan Stanley was incorporated, and its 
organization was completed on September 16. The three principal of- 



Dayton Power and Light Company 385 

ficers were Harold Stanley, William Ewing and Henry S. Morgan, for- 
merly partners of J. P. Morgan & Co. They were joined in the new 
enterprise by two members of J. P. Morgan & Co/s Philadelphia firm 
of Drexel & Co., three senior employees of J. P. Morgan & Co., and 
a staff of employees also from that firm. Harold Stanley became presi- 
dent and director of the corporation, William Ewing became executive 
vice-president and a director, and Henry S. Morgan became treasurer, 
secretary and a director. Four of the others became vice-presidents and 
directors, and one was made assistant treasurer and assistant secretary. 
All of these persons still occupy their original positions, the only changes 
occurring to date being the addition in 1936 of two vice-presidents and 
directors. These were Alfred Shriver, formerly president and a director 
of Guaranty Company of New York, and Sumner B. Emerson, formerly 
a vice-president of Fire Association of Philadelphia and associated com- 
panies. 

... At the inception of Morgan Stanley, pecuniary interests in its 
capital and surplus were held as follows: 

Owners Amount Per Cent 
Individual partners of J. P. Morgan 

& Co. — preferred stock $6,600,000 88% 

Officers and directors of Morgan Stanley, 

preferred stock 400,000 5.33^% 1 12% 

common stock and surplus 500,000 6.66 j% J 

Total capitalization and surplus $7,500,000 100% 

In August, 1937, the number of common shares was increased to 
200,000, and the additional shares were distributed to the then holders 
of common stock in proportion to their holdings. At the present time the 
common shares are still held only by the officers and directors of Morgan 
Stanley and the three largest stockholders, holding 20 per cent each, are 
Harold Stanley, William Ewing and Henry S. Morgan. 

The interests of the partners of J. P. Morgan & Co. in the preferred 
stock of Morgan Stanley have been reduced, principally by the death of 
two partners, partly by transfers. On August 31, 1939, partners of J. P. 
Morgan & Co. owned 30,700 out of the 70,000 shares of outstanding 
preferred stock, while 20,000 of the outstanding shares were held by 
the estate of a deceased partner and a total of 3,100 shares were held by 
two partners in trust. In the meantime the equity attributable to the 
common stock had increased from the original $500,000 to nearly 
$3,000,000 so that on the basis of the net worth of Morgan Stanley 



386 Case Problems in Finance 

as of August 31, 1939, pecuniary interests therein were held approxi- 
mately as follows: 

Owners Amount Per Cent 
Living partners of J. P. Morgan & Co., individually 

and in trust, preferred stock $ 3,580,000 35.8% 

Estate of deceased partner of J. P. Morgan & Co., 

preferred stock 2,000,000 20.0% 

Others, preferred stock 170,000 1.7% 

Officers and directors of Morgan Stanley, 

preferred stock 1,250,000 12.5% 1 42 .0/ 

common stock and surplus 3,000,000 30.0% j 

Total capitalization and surplus $10,000,000 100.0% 

Aggregate income in dividends on the preferred stock held by living 
partners of J. P. Morgan & Co. has ranged from $396,000 in 1935 
down to $143,200 in 1939. When the nine partners of J. P. Morgan & 
Co. invested in the preferred stock, they were as hopeful as the officers 
and directors of Morgan Stanley that the enterprise would succeed. It 
was clearly to their own pecuniary advantage to secure as much under- 
writing business for Morgan Stanley as possible. 

Our conclusion is that at all times since the formation of Morgan 
Stanley, the pecuniary interests of the leading partners of J. P. Morgan 
& Co. have been such that those partners have had a powerful incentive 
to secure what business they could for Morgan Stanley. We do not deem 
it necessary to find in this case that the partners of J. P. Morgan & Co. 
exert an influence over the management and policies of Morgan Stanley. 
The failure to so find, however, does not weaken the force of our con- 
clusion that there was an identity of pecuniary interest. It is not to be 
supposed that partners of J. P. Morgan & Co. would have to possess 
influence over Morgan Stanley to induce it to accept such high-grade 
underwriting business as they were able to procure for it. 

( 3 ) ]' P- Morgan & Co. has occupied such an influential position 
in United that Morgan Stanley has been placed in a preferred position 
with respect to the financing of Columbia subsidiaries, including Dayton. 

J. P. Morgan & Co.-Drexel & Co., together with Bonbright & Com- 
pany, Incorporated, an investment banking house then controlled by 
Landon K. Thorne and Alfred L. Loomis, organized United in January, 
1929. The organizers and an afliliated company initially turned over to 
United cash in the amount of $20,000,000 and large amounts of voting 
securities of United Gas Improvement Company, Public Service Cor- 



Dayton Power and Light Company 387 

poration of New Jersey, and Mohawk Hudson Power Corporation, 
causing United to issue to them its preferred and common stock and 
option warrants in exchange for such cash and securities. The initial 
board of directors of United consisted entirely of representatives of the 
Morgan-Thorne-Loomis groups. Shortly thereafter, George Howard was 
added to the board and elected President of United. He has retained 
these positions to this date. Having established their representatives on 
United's board of directors the organizers proceeded to dispose of their 
holdings of United's preferred and common stock to their clients. But 
in spite of the organizers' small holdings of United's voting securities, 
they continued to retain their dominant position on the board of direc- 
tors, partly through control of the proxy machinery. No opposition was 
ever encountered from the stockholders, few of whom ever attended 
meetings in person. 

The evidence is conflicting as to what purposes the organizers had 
in mind when they formed United. The Morgan-Drexel firms had been 
underwriters for the U.G.I, and Public Service systems for many years, 
had held minority interests in their securities, and had representatives on 
their boards of directors. There is evidence that around 1928 outside 
financiers in the utility business had approached either U.G.I, or Public 
Service with the idea of buying into those companies, and that there 
were discussions among the Philadelphia partners of Drexel & Co. as to 
the dangers that might come from such activities. Early in 1928 J. P. 
Morgan & Co. purchased substantial additional blocks of U.G.I. and 
Public Service stock, and discussed with other stockholders the advisabil- 
ity of working in concert. 

At about the same time General Electric Company asked J. P. 
Morgan & Co. to buy a substantial amount of securities of Mohawk 
Hudson. Thorne and Loomis had been discussing with Morgan partners 
for some time the benefits to be gained from utility investments, but 
the Morgan-Drexel firms already had a good many millions of dollars 
tied up in their portfolio of U.G.I. and Public Service stocks. Rather than 
increase their own utility portfolio, therefore, they decided to form a 
holding company to take over not only the proffered Mohawk Hudson 
securities but also their U.G.I. and Public Service holdings together with 
the even larger holdings therein of The American Superpower Corpora- 
tion. This enabled the Morgan-Drexel firms to reduce their portfolio of 
utility investments without disrupting the market prices thereof, and 
through the sale of the holding company securities, to realize a sub- 



388 Case Problems in Finance 

stantial profit on their investment and yet retain and even increase their 
influential position with the constituent utihty systems. 

In preparing a memorandum to be used in the sale of United stock, 
it was of interest to J. P. Morgan & Co. to see how other holding com- 
panies lacking in diversification of investments had dealt with that 
problem in their advertising. On January 2, 1929, Thomas S. Lamont, 
who had just become a partner of J. P. Morgan & Co. but who had been 
in its employ for some years, wrote a letter to the firm's lawyer reading 
in part as follows: 

"In this connection the names of two other investment trusts oc- 
curred to me, the purposes of which are in a way similar to the one 
proposed, in that they make little if any pretense of diversification, and 
their purpose is obviously to insure continued control by the bankers 
. . . and their clients." 

Realistic as this statement seems, there was testimony denying that 
continued control was among the purposes of the bankers in organizing 
United. But whatever the purposes, the effect was (a) to assure the 
continuation of the position of the Morgan-Drexel firms in the leader- 
ship of U.G.I, and Public Service financing; (^) to obtain for J. P. Mor- 
gan & Co. the leadership in the financing of Niagara Hudson (which 
was created by the consolidation of Mohawk Hudson and other upstate 
New York utilities); and (c) to assure to Bonbright & Company, In- 
corporated, an important participation in all such financing. Later, when 
the Morgan-Drexel firms went out of the investment banking business 
and Morgan Stanley was formed, Morgan Stanley succeeded to the 
leadership in the underwriting transactions of companies in these sys- 
tems. 

United did not acquire the bulk of its holdings in Columbia common 
stock until May, 1930, when through an exchange offer apparently 
instigated by P. G. Gossler, then Columbia's president, it obtained 
nearly 25 per cent of Columbia's outstanding common stock. Before 
that, however, Gossler had expressed a personal interest in United, 
buying some of its stock and selling to United some of his personal 
holdings in Columbia. 

On May 14, 1930, the United board caused a letter to be sent to 
Columbia offering to acquire approximately 25 per cent of the out- 
standing shares of Columbia's common stock, and to issue in exchange 
for each share so acquired ^ of a share of United's preference stock and 



Dayton Power and Light Company 389 

H shares of its common stock. One of the terms of the offer was that 
upon consummation of the exchange, Gossler should be elected a di- 
rector of United. Columbia's board approved the offer and resolved to 
recommend to the Columbia stockholders "that they deposit at least 
25 % of their holdings pursuant to said proposal." A circular dated May 
16 was sent out to all Columbia stockholders by the Columbia manage- 
ment, urging their acceptance on the ground that: 

''It is expected that the close association of The United Corporation 
with Columbia Gas & Electric Corporation as a result of this acquisition 
of stock will facilitate the making available of the great natural gas 
resources of the Columbia System to the large industrial and domestic 
markets along the eastern seaboard. 

"Your Board of Directors believe that the proposal made by The 
United Corporation is of advantage to Columbia Gas & Electric Cor- 
poration and its Shareholders. . . ." 

Stanley, who was then a member of the Columbia board and execu- 
tive committee, a partner of J. P. Morgan «& Co. and admittedly an 
influential factor in (though not then formally a director or officer of) 
United, approved the form and content of this letter to stockholders. 
Gossler was one of the officers who signed the letter, and was also one 
of three Columbia officers who set themselves up as a stockholders' 
committee to work for the success of the plan. This committee employed 
J. P. Morgan & Co. as depositary. Columbia itself agreed to and did share 
all expenses equally with United, including a fee of $200,000 to J. P. 
Morgan & Co. The result of the transaction, in respect of which Co- 
lumbia paid expenses to the extent of $178,684.06, was the acquisition 
by United of over 2,000,000 shares of the outstanding common stock 
of Columbia. Gossler was duly elected to the United board of directors. 

From the foregoing and from the testimony it appears that Colum- 
bia was hopeful of expanding its business through contacts and leader- 
ship which it would gain by joining the United group. For whatever 
purpose the acquisition by United was made, it did not result in an 
immediate transfer of Columbia's financing to the Morgan-Drexel or 
Bonbright interests. 

Guaranty Company of New York had been Columbia's investment 
banker since 1922, and continued as such until it was dissolved as a 
result of the Banking Act in June, 1934. Meantime, no effort was made 
by J. P. Morgan & Co. to obtain Columbia's underwriting business for 



390 Case Problems in Finance 

itself or to participate in that which was headed by the Guaranty Com- 
pany. 

Stanley, who as president of the Guaranty Company had handled 
Columbia financing prior to 1928 (at which time he became a Morgan 
partner ) , testified that in his experience with J. P. Morgan & Co. the 
firm had never approached a company for underwriting business where 
such company already had a satisfactory banking relationship with 
others; and that he knew personally that Columbia had satisfactory re- 
lations with the Guaranty Company. It may well be supposed, moreover, 
that J. P. Morgan & Co. would not be inclined to compete with the 
Guaranty Company, which was a subsidiary of Guaranty Trust Com- 
pany, a large and friendly institution on whose board at least two 
Morgan partners sat. 

After the Guaranty Company had gone out of the investment bank- 
ing business, however, Stanley told Gossler in the summer of 1935 
that he and others of J. P. Morgan & Co. planned to go back into the 
investment banking business. Gossler told his associates at Columbia 
that if that happened, he would probably want this new organization 
to take the leadership in a refunding operation then contemplated for 
Dayton. The refunding operation in question had been first undertaken 
with other investment bankers but had been postponed in April because 
of the impossibility of getting a satisfactory commitment from the bank- 
ers prior to the date for publishing the notice calling the outstanding 
bonds for redemption. Negotiations with these bankers were thereafter 
continued during the summer with the idea of getting out the issue in 
the fall. Meanwhile these bankers were informed of Gossler's tentative 
decision, in which the other officers of Columbia and Dayton concurred, 
and a few days after public announcement of the formation of Morgan 
Stanley, it was arranged that Morgan Stanley should manage the Dayton 
issue. This was a $20,000,000 issue of Dayton 3i% bonds due I960, 
offered to the public in October, 1935. 

Columbia has continued since then to have Morgan Stanley lead 
its subsidiaries' bond issues, and its officers, according to their own 
testimony, have not thought seriously about employing any other under- 
writer for that purpose. 

Since the present relationship of Morgan Stanley with Dayton and 
Columbia grew out of the Dayton bond issue of 1935, it is pertinent to 
examine the circumstances that might have led to Columbia's selection 
of Morgan Stanley as leading underwriter at that time. Counsel for the 



Dayton Power and Light Company 391 

Public Utilities Division maintain that the selection was made because 
of existing affihations, while Dayton and Morgan Stanley contend that 
it was because of the confidence the Columbia officers placed in Stanley 
personally and in others who went into the new organization with him, 
and because Columbia wanted the services of a strong firm with ade- 
quate capital. There is no real inconsistency in these two contentions, 
and each of the reasons given undoubtedly played its part. 

It was on September 10, 1935, that Gossler, in behalf of Columbia, 
went to Stanley and arranged for Morgan Stanley to manage the under- 
writing syndicate for the proposed issue. On that date Stanley was still 
a partner of J. P. Morgan & Co., for though the formation of Morgan 
Stanley had been announced, the corporation had not yet been organized 
for business. On that date seven of the eight directors of the United 
board were: Harold Stanley, George Whitney and Edward Hopkinson, 
Jr., all partners of J. P. Morgan & Co.; their fellow organizers of 
United, Landon K. Thorne and Alfred L. Loomis; George Howard, who 
was chosen by both groups to be president of United; and F. L. Carlisle, 
chairman of Niagara Hudson ( a subsidiary of United ) and of Consoli- 
dated Gas Company of New York ( in which United held a substantial 
interest and which has since changed its name to Consolidated Edison 
Company of New York ) . That had also been the situation when, a few 
months earlier, Stanley had informed Gossler that he and others of 
J. P. Morgan & Co. were probably going back into the underwriting 
business in the fall. 

On the other hand it is urged by respondents that such matters had 
nothing to do with the selection of Morgan Stanley as leading under- 
writer for the Dayton bond issue of 1935. Three days after that selection 
had been made, Stanley's resignation from the firm of J. P. Morgan & 
Co. took effect, and a few days later he resigned as a director of United. 
He had had a close personal and business relationship of long standing 
with Gossler long before he became a partner of J. P. Morgan & Co., 
as Gossler had been a friend and former employee of Stanley's father. 
In 1922, when Columbia's predecessor company terminated its banking 
relations with A. B. Leach & Co., Stanley was president of Guaranty 
Company and an officer of Guaranty Trust Company, and it was testified 
that it was largely for that reason that Gossler established banking re- 
lations with Guaranty for the Columbia system. Stanley personally 
worked on Columbia financing for some years before going over to 
J. P. Morgan & Co. He was on Columbia's board of directors and execu- 



392 Case Problems in Finance 

tive committee from 1922 until February 1935, and was held in high 
esteem by the management. Edward Reynolds, then executive vice- 
president and now president of Columbia, had worked under him at the 
Guaranty Company years before. 

Accepting the argument that all these and other similar considera- 
tions were influential in the original selection of Morgan Stanley, the 
conclusion is nevertheless inescapable that J. P. Morgan & Co. in 
September, 1935, had such an influential position in the management of 
United that Morgan Stanley was placed in a preferred position with 
respect to its selection as leading underwriter for the Dayton bond 
issue of 1935, and we so find. 

We also find that Morgan Stanley was in a preferred position with 
respect to its selection and its conduct of negotiations as leading under- 
writer for bond issues in the amounts of $35,000,000 and $10,000,000 
in 1936 and 1937, of Cincinnati Gas & Electric Company, another Co- 
lumbia subsidiary. In 1936, Dayton sold preferred stock with W. E. 
Hutton & Co. as leading underwriter. The record shows, however, that 
Columbia oflicers spoke to Morgan Stanley representatives about this 
proposed issue beforehand, while the issue was still under consideration 
and plans were being made to use W. E. Hutton & Co. Morgan Stanley, 
in keeping with its general practice of not participating in equity security 
underwritings, agreed that it would not be interested in the preferred 
stock issue. In March, 1937, Dayton placed $1,500,000 bonds privately. 
Apparently this small private placement, however, was not effected until 
the matter had been talked over with Morgan Stanley representatives. 
Our finding with respect to Morgan Stanley's preferred or inside position 
is based not only upon the continuous banking relationship then existing 
between Columbia and Morgan Stanley, but also on the fact that at the 
time of the underwriter's selection in those issues, four of the five direc- 
tors on the United board were George Whitney, Landon K. Thorne and 
George Howard, whose connections have already been described; and 
Thomas H. Stacy, an interim director elected to make up a quorum, 
and who had previously been employed by Howard and was serving as 
United's bookkeeper. 

It remains to be seen what the position of Morgan Stanley was in 
November, 1939, when it was selected as the leading underwriter for 
the Dayton bond issue of 1940. 

The question whether, with respect to the Dayton bond issue of 
1940, the relation between Dayton and Morgan Stanley was such that 



r :, 



Dayton Fower and Light Company 393 

there was liable to have been an absence of arm's-length bargaining 
between them within the meaning of paragraph (a) (3) of the Rule. 

There can be no question but that Morgan Stanley had a preferen- 
tial position over other underwriting houses when the time came for 
Columbia to select a leading underwriter for the Dayton bond issue of ^ 

1940. For one thing, it was in a preferred position because of its histori- 
cal relationship to United and the Columbia system. For another, it was 
in a preferred position in the sense that continuous investment banking 
relations still existed between it and the Columbia system and the Co- 
lumbia officers gave no serious thought to seeking other investment 
bankers. 

Aside from the historical and continuing banker relations, we find 
other evidence of a special relationship existing between Columbia and 
Morgan Stanley at the time the latter was selected to lead Dayton's bond 
issue of 1940. On March 28, 1938, the day of the United States Supreme 
Court decision in Electric Bond and Share Co. vs. SEC upholding the 
constitutionality of the registration provisions of the Holding Company 
Act, United registered as a holding company under the Act and Whitney 
and Thorne resigned from the United board. 

Elimination of banker influence over holding company and utility 
managements is a duty given us by Congress. Section 17 (c) of the Act 
provided the initial step in that direction by prohibiting registered hold- 
ing companies and their subsidiaries from having officers or directors 
with banking connections except where the Commission decided that 
there would be no adverse effect upon the public interest or the interest 
of investors or consumers. Apparently in view of this provision, George 
Whitney resigned from the United board of directors. In our opinion, 
however, that resignation did not sever the special relationship that 
existed between the Morgan interests and United. 

This problem of banker domination or special influence is not new 
nor is it limited to the utility field. It has been demonstrated in similar 
instances that the mere fact that a banker cannot sit on the board of 
directors of a client company does not necessarily change the banker's 
influential position with respect to his client. For instance. Section 10 
of the Clayton Anti-Trust Act provides, in effect, that if a banker sits on 
the board of directors of a common carrier company, his firm may not 
underwrite the securities of that company in amounts of more than 
$50,000 in any one year, except after competitive bidding. The reports 
of the Senate Committee investigating railroads, holding companies and 



394 Case Problems in Finance 

affiliated companies show that absence of official board representatives 
because of this Clayton Act provision did not prevent investment bank- 
ers from continuing to dominate the financial policies of railroad sys- 
tems. 

On the board of United at the time of the present underwriting 
transaction there were five directors: George Howard, president of 
United practically since its inception; F. L. Carlisle and Roy K. Fer- 
guson, chairman and president, respectively, of the St. Regis Paper 
Company and affiliated interests, which control 7.9 per cent of United's 
voting securities, the largest block held by any unified group; John J. 
Burns, a former general counsel of this Commission, presently engaged 
in the general practice of the law and retained as counsel for United; 
and Edward H. Luckett, who had come to United recommended by an 
attorney whose firm acted as counsel for Niagara Hudson. The original 
election of Howard, Carlisle and Ferguson had been approved by part- 
ners of J. P. Morgan & Co., and both Howard and Carlisle had done 
business with the Morgan-Drexel firms for years. Howard's relationship 
to the Morgan interests appears to have been intimate. Originally placed 
on the United board as president by the Morgan and Thorne-Loomis 
groups, the record shows his reliance on George Whitney, leading 
representative of J. P. Morgan & Co. on the United board. Despite 
Whitney's resignation from the board of United, Howard's behavior 
toward Whitney in regard to United matters, as we shall hereinafter 
relate, has been that of a man who feels that he owes Whitney courteous 
fealty. 

Carlisle came in contact with J. P. Morgan & Co. when that firm, 
representing United's large interest in Mohawk Hudson securities, par- 
ticipated with Carlisle, the Schoellkopfs and others in organizing Ni- 
agara Hudson Power Corporation, a subsidiary of United. Niagara 
Hudson was the result of a consolidation between several upstate New 
York utilities, among which were Mohawk Hudson and Northeastern 
Power Corporation. Carlisle had for some years been president of North- 
eastern, and represented it in conferences with the Morgans and others 
in formulating the plan of consolidation. He was made chairman of the 
board of Niagara Hudson at its inception and has held that position 
ever since. In 1930 he was first elected to the United board of directors 
along with the other titular heads of companies in which United was 
substantially interested. At about the same time he and George Whitney 
were elected to the board of trustees of Consolidated Gas Company of 



Dayton Power and Light Company 395 

New York (now Consolidated Edison Company of New York), and 
in 1932 Carlisle was made its chairman. Since its inception Morgan 
Stanley has been the almost invariable leader in both Niagara Hudson 
and Consolidated Edison public debt financings. 

The record indicates that both Howard and Carlisle have frequently 
relied on George Whitney, a leading partner of J. P. Morgan & Co., 
and formerly the principal representative of J. P. Morgan & Co. on the 
United board. Although Whitney resigned from the board of United 
on March 28, 1938, the following facts cause us to believe that only 
the outward appearance of a changed relationship between J. P. Morgan 
& Co. and United had thus been effected. 

For about six months after the resignations of Whitney and Thorne, 
reports which were ordinarily sent only to directors of United continued 
to be sent to them. George Howard testified that this was done by mis- 
take and that when he found out about it he stopped it. 

Yet the influence of George Whitney did not cease thereafter. In 
August, 1938, United received a letter from William O. Douglas, then 
Chairman of this Commission, relating to compliance by United and its 
subsidiaries with Sections 11 ( b ) ( 1 ) and 11 (b) (2) of the Holding 
Company Act. Thereafter a reply to that letter was composed by the 
board of directors of United in which there was outlined a future pro- 
gram for United. After that reply had been prepared Howard showed 
it to Thorne and also went to Whitney and submitted it to him for advice 
and suggestions. This took place around November, 1938. A program 
for meeting the integration provisions of the Act was, of course, of great 
importance to United and its subsidiaries. Of what importance it might 
have been to J. P. Morgan & Co., at that time a commercial bank, is 
not clear. Yet Whitney who had left the United board some eight 
months before was consulted by the president of United prior to for- 
warding an integration program to the Commission. If, as this incident 
might indicate, Whitney's advice continued to be regarded as influential, 
it would appear that members of the United board were not yet free 
from the influence of J. P. Morgan & Co. 

In August, 1938, United effected a so-called quasi-reorganization 
which involved the write-down of the carrying value of United's invest- 
ments by some $400,000,000. Howard went to Whitney prior to put- 
ting the program into effect and talked over this situation. It was 
testified that since the result of the write-down was to stop the payment 
by United of dividends on its preferred stock for which J. P. Morgan 



396 Case Problems in Finance 

& Co. were paying agents, Howard went and explained this to Whitney 
"only because I knew many inquiries would come to his firm about the 
paying of those dividends and I wished him to understand it." Embarka- 
tion upon this quasi-reorganization, like the integration program, was a 
momentous step by United. It is noteworthy that once again Whitney, 
no longer formally associated with United, was sought out before the 
step was taken by United. It is at best doubtful whether J. P. Morgan 
& Co.'s interest in the quasi-reorganization as paying agent required 
consultation with George Whitney, a member of the firm, before United 
finally decided to effect this financial program. We think the incident is 
one more indication that J. P. Morgan & Co., through George Whitney, 
continued to wield influence in the determination of United's significant 
affairs. 

The sequel to United's quasi-reorganization also involved George 
Whitney. Due to the quasi-reorganization, a deficit in United's consoli- 
dated earned surplus account resulted and dividends could not be paid. 
Consequently, cash accumulations, which could not be paid out in divi- 
dends, increased to about $8,000,000. United had on file with this 
Commission in the early part of 1939 an application under Rule U-9C-4 
for permission to engage in a program of investing this cash in non- 
utility securities. Howard's testimony shows that he consulted Whitney 
about this program too. His explanation was that opposition to this 
projected program had arisen in Philadelphia and he believed that 
Whitney might suggest how the opposition might be eliminated. 

The continued existence of a special relationship between Morgan 
Stanley and United and its subsidiaries is made clear by a review of the 
bond and debenture financings by companies in the United group. It 
is a matter of record that Morgan Stanley is not favorably disposed to- 
ward underwriting equity securities. Since Morgan Stanley's under- 
writing business rests nearly entirely upon debt securities, we have 
attempted to analyze such security issues by the United group companies. 
The record in this proceeding covers the debt financings of subsidiaries 
in the Columbia Gas & Electric, Niagara Hudson, Public Service of 
New Jersey, and United Gas Improvement systems, all of which are 
subsidiaries of United. In addition, the record covers debt financings by 
companies in the Consolidated Edison Company of New York system. 
We have also included the debt financing record of companies in The 
Commonwealth & Southern Corporation system. 

The record shows that from September 1935, the date of the for- 



Dayton Power and Light Company 397 

mation of Morgan Stanley, to February 1940, the close of the hearings 
in this proceeding, Morgan Stanley has been the leading underwriter in 
every public financing of bonds or debentures by these United companies 
except in three instances. The three exceptions involved the issuance of 
securities by Connecticut Light & Power Company and were under- 
written in each instance by Putnam & Co. and Scranton & Co., under- 
writers located in Connecticut. These three exceptions are probably 
attributable to the strong policy of promoting local control expressed in 
the Connecticut statute which provides that no foreign holding company 
shall control or interfere with the operations of Connecticut gas and 
electric companies, like Connecticut Light & Power Company. In view 
of this statutory provision, it is not hard to understand why Morgan 
Stanley, through United influence, did not head Connecticut financings. 

The significant uniformity of underwriting by Morgan Stanley of 
the above-mentioned United companies is, of course, true only of pub- 
licly offered debt security issues. In the past several years, there have 
been several long-term private financings by these companies. Careful 
analysis of these private placements reveals that nearly all of them have 
been for relatively small amounts, only five of them exceeding 
$10,000,000 in amount. Of these, the only large private placement took 
place in the fall of 1939 when the outbreak of the European war made 
the public markets unstable and public offerings were risky. It is also 
noteworthy that one of these substantial private placements was made 
by Connecticut Light & Power Co. We have already considered the spe- 
cial local statutory considerations which govern the operations of Con- 
necticut utilities. Finally, it appears that two other substantial private 
placements were made by subsidiaries of Consolidated Edison Company 
of New York which is not a statutory subsidiary of United. We believe 
that the private placements listed in this record are not inconsistent 
with the existence of a relationship between Morgan Stanley and sub- 
sidiary companies in the United group such as is embraced by our Rule. 
This special relationship might well exist without resulting in exclusive 
participation by Morgan Stanley in all United system financings. 

In conclusion, it should be noted that Morgan Stanley has not 
headed the financing of any public utility company, as defined in the 
Act, except subsidiaries of United and companies in the Consolidated 
Edison and Commonwealth & Southern systems. Confinement of Mor- 
gan Stanley's underwriting leadership of utility securities to companies 
in the orbit of United is particularly interesting in view of repeated 



398 Case Problems in Finance 

testimony by respondents in this record that Morgan Stanley was success- 
ful in obtaining United system financings only because it was a strong 
firm with adequate capital and furnished satisfactory services. 

There are, of course, powerful economic incentives for investment 
bankers to strengthen their influence over the management and policies 
of holding companies and their subsidiaries. Not only does such influ- 
ence assure the banker of the profits from underwriting, but there are 
additional emoluments which come from the ability to select custodians, 
depositaries, transfer agencies and coupon and dividend paying agencies. 
This is a type of financial patronage which customarily goes to the 
banker who is able to exert influence over the financial policies of a 
utility system. In connection with the present proceeding, it is note- 
worthy that J. P. Morgan & Co. has always been the transfer and divi- 
dend paying agent for the United Corporation. From its very inception. 
United Corporation has maintained a substantial deposit account with 
J. P. Morgan & Co. From 1934 Columbia Gas & Electric Corporation 
has maintained a sizable deposit account with J. P. Morgan & Co. And 
J. P. Morgan & Co. has always been custodian for securities owned by 
United. J. P. Morgan & Co. has also been the coupon paying agent for 
bond issues of numerous companies in the United group. 

This brings us down to the Dayton bond issue of 1940 which occa- 
sioned the Commission's order to show cause pursuant to Rule U-12F-2. 
This involved the issue and sale by Dayton of $25,000,000 principal 
amount of First Mortgage Bonds, 3% Series Due 1970, to underwriters 
for resale to the public. The bonds were sold to a group of 38 underwrit- 
ers, headed by Morgan Stanley, at a price of 102^. They were offered to 
the public at a price of 104, resulting in a spread of 1| points, or under- 
writing discounts or commissions totaling $437,500. Of the spread of 
1| points, Morgan Stanley was to receive ^ of a point for services as 
syndicate manager; underwriters, including Morgan Stanley, were to 
receive | of a point for wholesale sales; and | of a point was to be 
received for retail distribution. The total fees to be received by Morgan 
Stanley, upon successful placement, aggregated $100,562.50. 

It was estimated that, subject to certain qualifications, the refunding 
portion of the proposed financing would effect an annual saving to 
Dayton of approximately $48,000 (after allowing for federal income 
taxes ) . Dayton also benefited from the extension of the maturity date 
of $19,015,000 of its previously outstanding debt from I960 to 1970. 

Some of the circumstances surrounding this security issue have 



Dayton Power and Light Company 399 

caused us concern. The amount of new money involved was about 
$5,700,000. It appears from the record that when Morgan Stanley was 
first approached in regard to the instant financing, the Columbia officials 
had in mind a security issue of either stocks or bonds to raise only this 
new money. Morgan Stanley advised that bond financing for the new 
money was sound. And Morgan Stanley on this occasion also suggested 
refunding outstanding Dayton bonds in the same financing with the new 
money issue. R. H. Delafield, financial Vice-President of Columbia, testi- 
fied that Columbia officials had previously made many studies in regard 
to refunding the $19,015,000 outstanding Dayton bonds. 

Dayton, of course, got cheap money which cost it only 2.91 per cent 
per annum. But in order to obtain this cheap money it had to pay sub- 
stantial call premiums of $855,675, and expenses of about $125,000. 
The maturity date of the refunded debt was extended 10 years. Yet the 
refunded debt was not to mature until I960, scarcely a pressing obliga- 
tion requiring refunding. Dayton's annual saving of $48,000 over the 
life of the refunded bonds, approximately $1,000,000, is to be compared 
with the Morgan Stanley commission of $100,562.50 and the 
$336,937.50 which other underwriters and dealers obtained from the 
financing. Dayton's savings should also be considered in the light of the 
cost of the refunding to investors in these Dayton bonds. Investor good 
will, often deemed an attribute of the public offering method as distin- 
guished from private placements, is scarcely likely to be encouraged by 
frequent refundings accompanied by small savings to the issuer. 

Although these facts have caused us concern, we recognize that the 
price of 104 to the public and 102^ to the company were not discernibly 
out of line with the prevailing market, and the spread of 1 1 for the un- 
derwriters was among the lowest of those taken on comparable public 
utility issues during the last five years. Of course most of these negotia- 
tions took place while the hearings in this proceeding were being con- 
ducted, and that circumstance must have affected the outcome. 

II 
OPINIONS OF THE CIRCUIT COURT OF APPEALS 

Following the promulgation of the above opinion, the matter was 
appealed to the Circuit Court of Appeals. A majority of the three-judge 
court affirmed the SEC decision. Separate opinions were written by each 
judge. Judge Learned Hand, one of the majority, said in part: 



400 Case Problems in Finance 

". . . , there was 'substantial evidence' to support the finding; that 
is to say evidence from which a reasonable man might conclude that such 
a chance existed and that the danger was immediate enough to make its 
removal 'appropriate.' I do not say that personally I should have come 
to that conclusion, but there had been enough in the relations between 
the United Company and the Morgan firm to permit the conclusion that 
the familiarity, recourse for advice, reliance, control and habitude of the 
past might perhaps unconsciously prove the casting straw. Congress ap- 
pears to me to have been jealous of the results of the slow cumulation of 
such factors and to have wished to endue the Commission with power 
to decide when it was the course of prudence to eliminate the possibility 
of its influence. The Supreme Court in decisions of which Gray v. 
Powell, 62 S. Ct. 326, is the latest, has unequivocally set the narrowest 
limits upon our review in such situations. The vague outlines of the 
issue itself, coupled with this circumscription of our powers, leaves us 
little or no scope. 

Judge Chase, dissenting, said in part: 

It is obvious that, by the statutory definition of afi&liate in Section 
2 (a) (11) (D) of the Act, 15 U.S.C.A. Section 79b (a) (11) (D), 
as "any person or class of persons that the Commission determines, after 
appropriate notice and opportunity for hearing, to stand in such relation 
to such specified company that there is liable to be such an absence of 
arm's-length bargaining in transactions between them as to make it nec- 
essary or appropriate in the public interest or for the protection of in- 
vestors or consumers that such person be subject to the obligations, 
duties, and liabilities imposed in this chapter upon afi&liates of a com- 
pany." Congress has delegated to the Commission very broad and com- 
prehensive power to declare who is, or is not, within the reach of the 
statute. For present purposes, I shall assume that this delegation of 
power is as full and complete as it may be and still be within the con- 
stitutional limitations upon Congress recognized in Schechter Poultry 
Corp V. United States, 295 U.S. 495, 55 S. Ct. 837, 79 L. Ed. 1570, 97 
A.L.R. 947, and Panama Refining Co, v. Ryan, 293 U.S. 388, 55 S. Ct. 
241, 79 L. Ed. 446. Even so, there must be some standard of interpreta- 
tion less vague than the Commission's uncontrolled discretion. Compare 
Champlin Refining Co. v. Corporation Commission of Oklahoma, 286 
U.S. 210, 52 S. Ct. 559, 76 L. Ed. 1062, 86 A.L.R. 403; A. B. Small Co. 



Dayton Power and Light Company 401 

V. American Sugar Refining Co,, 26l U.S. 233, 45 S. Ct. 295, 69 L. Ed. 
589; United States v. L. Cohen Grocery Co., 255 U.S. 81, 41 S. Ct. 298, 
65 L. Ed. 516, 14 A.L.R. 1045; International Harvester Co. v. Ken- 
tucky, 234 U.S. 216, 34 S. Ct. 853, 58 L. Ed. 1284. What is 'liable to be 
or to have been' is, indeed, an elastic expression which, when applied to 
the rather uncertain concept of what may be 'such an absence of arm's- 
length bargaining ... as to make it necessary or appropriate in the 
public interest' to impose upon one the statutory status of an affiliate, 
gives the whole a meaning still more elusive. For that very reason it is 
especially important for a reviewing court to make sure that the Com- 
mission's order has substantial evidence to support the findings of fact 
upon which it is based. Only if there is substantial evidential support for 
them are they conclusive. 15 U.S.C.A. Section 79 x (a) . And this means 
support more firm than that afforded by suspicion, conjecture or but a 
scintilla of evidence. "It means such relevant evidence as a reasonable 
mind might accept as adequate to support a conclusion. . . ." 

The assumption of uncontrolled power has in this instance led the 
Commission to dispense with essential evidence in making its order and 
to arrive at a result unsupported by the facts under the law. That makes 
it necessary to review the facts briefly. 

The petitioner was organized by the partners of J. P. Morgan & Co., 
and they continued to have such an interest in its affairs that I agree 
there is evidence which would support a finding that, for the purpose of 
Rule U-12F-2, it and the Morgan firm may fairly be treated as one. 
That is by no means true, however, in respect to Dayton. There was no 
intimate relationship by way of stock interest. The Morgan partners had 
but a negligible, minute stock interest of less than ^ of 1 % even in 
United, and United owned only some 19-6% of the voting stock of 
Columbia Gas & Electric Corporation, of which Dayton was a wholly 
owned subsidiary. It is true that there had been in the past satisfactory 
business transactions between the men in what may be called generally 
the Dayton management and what may be equally generally called the 
Morgan firm. No doubt there were also personal friendships and it is 
scarcely to be doubted that what is often called goodwill in business was 
present. This would naturally lead Dayton to consider consulting the 
petitioner concerning this financing operation with a view to learning 
whether it was a feasible one and whether some agreement to have the 
petitioner undertake it could be reached. That was done and an agree- 



402 Case Problems in Finance 

ment was made under which the petitioner did do the work both, as is 
conceded by all, well and at a reasonable cost. The evidence will support 
no contrary findings which are of fact alone and no such findings were 
made. 

And so far as the present petition is concerned, it is to be taken for 
granted that the bond issue, in amount and otherwise, was in the public 
interest. It had been authorized by the Public Utilities Commission of 
Ohio and it had the approval of the Securities and Exchange Commis- 
sion to the extent of an order approving an application for exemption 
under Section 6 (b) of the Act, 15 U.S.C.A. Section 79Hh).Inre The 
Dayton Power and Light Company, 6 SEC 787. Obviously it was en- 
tirely proper for Dayton to sell these bonds and it was reasonable, if not 
absolutely necessary for Dayton to engage some underwriter to do that. 
If not the petitioner, someone else in that business. Consequently, one 
would naturally look for evidence in support of this order to indicate the 
likelihood that, if the petitioner did it, the work would not be as well 
done or would not be as economically done or would in some way not 
be as beneficial to Dayton and to the public as it would be if done by 
someone else. This record is barren of any such evidence. 

In the absence of proof, worthy of the name, to show that the peti- 
tioner had any means by which it could bend Dayton to its will, the 
Commission at long length, by extremely tenuous and subtle deductions, 
finally guessed itself into believing that there were subtle relationships 
which supported its ultimate conclusion that the petitioner should be 
denied its fee under Rule U-12F-2. Its opinion as filed discloses, without 
expressly admitting, that the Commission merely suspected what it con- 
cluded in this regard. The only tenable alternative is that it acted on in- 
formation it had which was not in evidence. If so, the order is palpably 
erroneous. As Mr. Justice Brandeis said in the Chicago Junction case, 
264 U.S. 258, 263, 44 S. Ct. 317, 319, 68 L. Ed. 667, 'Tacts conceiva- 
bly known to the Commission, but not put in evidence, will not support 
an order. Interstate Commerce Commission v. Louisville & Nashville 
R.R, Co., 227 U,S. 88, 93, 33 S. Ct. 185, 57 L. Ed. 431." And as the 
same learned justice also said in the same case ". . . to make an es- 
sential finding without supporting evidence is arbitrary action." 



INDEX OF CASES 



i 



/VVVVVVVWVVV\A\VVVV\A^\Aa\VVVWVVAA\\V\\\VVV\A\VVVVW 



Index of Cases 



/VVVVVVVVV\\VVV\AVVVVVVVVVVVVVV\\VVVV\\VV\V\/VVVVV^^ 



PAGE 

Adanac Packaging Machine Co 91 

American Woolen Co 249 

Bebb Corp. 242 

Boston Edison Co 235 

Buckeye Mold & Tool Co 332 

Cambridge Metal Products, Inc 337 

Cellulose Corp 149 

Central Maine Power Co. — Northern Indiana Public Service Co. . 201 

Clarkson Lumber Co 28 

Consolidated Motive Co 144 

Continental Casualty Co. (A) 182 

Continental Casualty Co. (B) 185 

Curtiss- Wright Corp 307 

Dayton Power and Light Co. — Morgan Stanley & Co., Inc. . . . 381 

DixleyPaperCo. (A) 130 

DixleyPaper Co. (B) 180 

Eagle Packing Co., Inc 370 

English Motor Sales, Inc . 9 

Garnet Abrasive Co., Inc 81 

Harbin Co 64 

Haward Manufacturing Co., Inc 105 

Hilton Co. 296 

Jay Textiles, Inc 165 

Johns-Manville Corp 189 

Jollum Grocery Corp 361 

LaFrance Industries 272 

Larabee Co 46 

Leary Motors 315 

Linwood Co 50 

Longstreet Machine Co 119 

405 



406 Index of Cases 

Loose- Wiles Biscuit Co 240 

Mayfair-Cottle Co 291 

McKellar Automatic Machine Co 212 

Megaphytic Products Co 18 

Mitchei's Store, Inc 349 

Monroe Department Store . 42 

Morgan Stanley & Co., Inc. — Dayton Power and Light Co. . . . 381 

Northern Indiana Pubhc Service Co. — Central Maine Power Co. . . 201 

Nostrand Pressure Casting Co 301 

Ohio Gauge Co 257 

Pure Oil Co 194 

Santos Coffee Co 72 

Scott Laundry Co., Inc 98 

Slater Quarry Corp 115 

Supra Development Corp 321 

Tremblant Manufacturing Co 33 

Trivett Manufacturing Co. (A) 56 

Trivett Manufacturing Co. (B) 62 

United American Manufacturing Co 39 

Vickery Department Store 139 



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